Why the SEC can’t easily solve Appointments Clause problem with ALJs

June 17, 2015

(Reuters) – It seems as though there ought to be an easy way for the Securities and Exchange Commission to stomp out claims that its in-house judges are unconstitutionally appointed through a bureaucratic process, a defense theory that has spread as fast among SEC defendants as viral cute-animal memes on the Internet. But the SEC has so far avoided even addressing the potential consequences of that quick fix – perhaps because the solution isn’t so simple after all. If the SEC changed the way it appoints in-house judges, the fix could call into question the outcome of scores of past and present SEC enforcement actions as well as cases at other regulatory agencies.

As you probably know, the constitutionality of administrative law judges, those workhorses of federal enforcement who preside over in-house proceedings for the agencies that employ them, is unquestionably the issue of the moment for white-collar and regulatory lawyers and defendants. In the past six months, SEC defendants have brought a raft of challenges to the agency’s ALJ regime, after the SEC’s enforcement division disclosed its intention of bringing more, and more complex, cases as administrative proceedings before in-house judges rather than federal court suits before U.S. district judges.

The recent challenges to SEC administrative proceedings do not just claim defendants’ due process rights were violated by evidentiary rules that favor the agency, arguments that have been kicking around for a few years without much success. The new theories, as I’ve previously explained, instead assert the SEC’s administrative law judge regime violates Article II of the U.S. Constitution under the U.S. Supreme Court’s interpretation of separation-of-powers doctrine in the 2010 case Free Enterprise Fund v. Public Company Accounting Oversight Board.

According to these arguments, SEC ALJs are “inferior officers” of the executive branch because they exercise enforcement power and not all of their decisions are subject to review by SEC commissioners. And as executive branch officers, defendants say, their appointment and retention are subject to Article II of the Constitution. The SEC’s ALJ system supposedly violates Article II in two ways: ALJs are unconstitutionally insulated from accountability to the president because they can only be dismissed by the commissioners, and only if a merits board finds good cause; and the in-house judges are unconstitutionally appointed because they are named through a bureaucratic process and not by the commissioners.

The latter of those two theories – first promulgated only in April by Skadden Arps Slate Meagher & Flom and Brune & Richard in distressed debt investor Lynn Tilton’s federal district court suit to block an SEC administrative proceeding – is quickly gaining momentum. In late May, the SEC commissioners requested briefing on the issue in an appeal by the real estate investment manager Timbervest and four Timbervest principals of a 2014 ALJ opinion holding them liable for violations of the Investment Advisers Act. The commissioners’ request signaled that, at the very least, they want a full record when they decide whether their in-house judges are properly appointed. The Enforcement Division responded last week with a six-page filing confirming that SEC administrative law judges are not hired by the commissioners but by the chief administrative law judge after candidates are recommended by the U.S. Office of Personnel Management.

Then last week, U.S. District Judge Leigh May of Atlanta ruled they are not. Judge May enjoined the SEC from moving forward with an administrative proceeding against real estate developer Charles Hill, finding that SEC in-house judges are, indeed, executive branch officers under Article II because they exercise significant judicial authority – and that, because ALJs are not directly named by the president or the SEC commissioners, their appointments violate Article II’s Appointments Clause.

Judge May said the constitutional flaw “could easily be cured by having the SEC Commissioners issue an appointment or preside over the matter themselves.” But that hasn’t happened, even as Judge May’s ruling reverberates. After she enjoined the SEC from proceeding against Hill, another Georgia judge, U.S. District Judge Amy Totenberg, referred to Judge May a similar case by another SEC target, Gray Financial Group, whose lawyers at Greenberg Traurig also raised the Appointments Clause defense May endorsed in the Hill case. Judge May has ordered a hearing on Gray Financial’s preliminary injunction motion to be held next month.

Meanwhile, Timbervest’s lawyers at McKenna Long & Aldridge filed a case in federal district court in Georgia, even as the SEC commissioners consider Timbervest’s appeal. Their case, which seeks to block the SEC from posting its final determination or enforcing penalties against the company and its principals until the end of the federal court case, is also before Judge May. The SEC, doubtless fearing another ruling from Judge May that its administrative law judges are unconstitutional, has asserted that Timbervest’s case isn’t related to the Hill case and shouldn’t have been assigned as such to Judge May; Timbervest defended its “related” designation in a filing Tuesday.

The SEC and its lawyers at the Department of Justice also sought to undercut Judge May’s holding in the Lynn Tilton case in Manhattan federal court, writing a letter dated June 10 to U.S. District Judge Ronnie Abrams describing why the Atlanta judge wrongly defined SEC in-house judges as executive branch officers.

But the most interesting SEC reaction to its Appointments Clause problem has come in a challenge to its administrative proceeding against former S&P official Barbara Duka. Duka’s case is before U.S. District Judge Richard Berman in Manhattan, who is no defense pushover: In a ruling in April, the judge rejected Duka’s argument that SEC in-house judges are unconstitutionally insulated from tenure review, denying her motion for a preliminary injunction because he said she was unlikely to succeed on the merits.

He has shown more curiosity, however, about the Appointments Clause. After Duka’s lawyers at Petrillo Klein & Boxer notified the judge about Judge May’s holding in the Hill case in Georgia, Berman asked the Justice Department, on behalf of the SEC, to brief whether the agency could easily cure the constitutional defect May found. The Justice Department’s June 15 response more or less ducked the question. The letter emphasized what the government considers to be Judge May’s flawed analysis of whether in-house judges are executive officers and said it would be premature for the SEC to change its ALJ regime until the conclusion of the government’s anticipated appeal of May’s ruling.

“Given the government’s position that the SEC ALJ is a mere employee, and not an inferior officer who must be appointed in a manner consistent with the Appointments Clause, the government does not believe the SEC has any obligation to pursue the courses of action discussed by Judge May,” the letter said. “The government believes that the Commission should not act precipitously to modify its ALJ scheme. This is particularly the case when the SEC has over 100 litigated proceedings at various stages of the administrative process and the ALJ scheme has been in use for seven decades and is grounded in a highly-regulated competitive service system that Congress created for the selection, hiring and appointment of ALJs in the executive branch.

Judge Berman wasn’t satisfied by that answer and instructed both sides to be prepared to answer questions at a hearing Wednesday afternoon about whether the SEC can make sure its five ALJs are constitutional by having the commission reappoint them.

I sent an email asking about the consequences of such a quick fix to SEC spokesman John Nester; he declined to comment. But defense lawyers in the thick of constitutional challenges to SEC ALJs shared some thoughts. Terry Weiss of Greenberg Traurig, who represents Gray Financial in the case just transferred to Judge May in Georgia, said it is telling that the SEC has not undertaken the “easy” cure the judge suggested.

Timbervest General Counsel Carolyn Seabolt and outside counsel Nancy Grunberg of McKenna said the agency has to be worried that any reappointment of its ALJs could be construed as an admission that their previous appointments were constitutionally unsound. Any defendant with a pending case before an SEC in-house judge – and even defendants previously tried in administrative proceedings – will be able to challenge the constitutionality of the regime in which they were tried.

And if the SEC tacitly concedes its in-house judges were unconstitutionally appointed, Grunberg said, other federal agencies are also going to have to look hard at the duties and appointment processes for their administrative law judges. If those judges have similar authority and aren’t appointed directly by commissioners, defendants in their cases may also be able to bring constitutional challenges. “This seems like something that could have major ripples,” Grunberg said.

The simple fix Judge May suggested, in other words, isn’t so simple at all.

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