On July 13, the Securities and Exchange Commission approved the adoption of amendments to the Rules of Practice that govern its administrative proceedings. The approval was announced with little fanfare eight months after the Dec. 4, 2015, closure of the period for public comment, although the amendments are largely consistent with the Commission’s original proposals, adopting most “as proposed” or “substantially as proposed.” Most prominently, the amendments potentially lengthen the prehearing stage of administrative proceedings, permit some depositions as a matter of right for each side in complex proceedings and explicitly provide for the exclusion of “unreliable” evidence. The amendments will apply to all proceedings initiated 60 days or more after their publication in the Federal Register, and apply to some pending actions, depending on the phase of the proceeding.
The amendments arrive amid a steady stream of legal challenges to the Commission’s increased use of its in-house forum following the passage of the Dodd-Frank legislation in 2010. Dodd-Frank authorized the Commission to impose monetary penalties in administrative proceedings on persons not associated with entities registered with the Commission; prior to Dodd-Frank, only the federal courts had this power. This change, as well as the Commission’s enhanced authority to bar persons from the securities industry in administrative proceedings (also granted by Dodd-Frank), has contributed to a significant spike in the Commission’s use of the in-house forum. Moreover, where in the past the Commission, even as to regulated persons, had tended to sue in federal court on complex matters, such as insider trading violations, more recently it has sued administratively in such cases as well. The Commission’s increased utilization of its in-house forum has unfavorably highlighted the differences between proceedings in that forum and in the federal district courts. The disparity in the Commission’s rate of winning verdicts — 90% in contested cases pursued in-house, compared with 69% in federal court — has also raised eyebrows.
Notably, in an SEC administrative proceeding, there is only limited document discovery and no deposition discovery; review of the administrative law judge’s (ALJ) tentative decision goes to the commissioners, who themselves approved the original filing of the proceeding; and an appeal of the Commission’s order is made to a federal court of appeals whose review is deferential to the Commission’s findings. In contrast, in a district court proceeding, the action is conducted before an Article III federal judge, there is a right to a jury trial, there is plenary discovery under the Federal Rules of Civil Procedure and the Federal Rules of Evidence apply.
Beginning with Gupta v. SEC in 2011, litigants have argued that the Commission’s administrative proceedings suffer from a number of constitutional deficiencies. These include violations of the due process clause (the SEC’s administrative procedures are inadequate), the equal protection clause (see, e.g., Gupta, where Judge Jed Rakoff denied the Commission’s motion to dismiss Mr. Gupta’s complaint, citing a “well-developed public record of Gupta being treated substantially disparately from 28 essentially identical defendants [who were charged in federal district court]”) and the appointments clause (claiming that ALJs are “inferior officers” and must under the Constitution be appointed by the president or “Heads of Departments”).
The Commission has responded with incremental reform. In May 2015, the Commission’s Enforcement Division issued formal guidance on the factors it will consider when choosing between instituting proceedings in-house and in federal court. However, those factors centered on the Commission’s convenience and enforcement priorities, as opposed to fairness to the respondent. The Commission’s recent approval of the amendments to the Rules of Practice seems to be an attempt to address specific criticisms of the in-house procedures, while leaving broader criticisms to the side. Although commenters, according to the Commission, “generally supported the Commission’s efforts to update the rules, expand the discovery process and enlarge the timetables in administrative proceedings,” some “argued that the proposed amendments were too incremental,” while others questioned “the legitimacy of the Commission’s administrative forum” altogether.
A number of the amendments are noteworthy:
While many of the amendments will be welcomed by defense practitioners (even if they are viewed as not going far enough in the right direction), not all of them favor respondents. For example, Rule 220 introduces a new requirement that a respondent must affirmatively state in her or his answer whether the respondent intends to assert a reliance-on-counsel defense. Commenters argued that the requirement “prejudices respondents, provides an unfair advantage to Division staff in administrative proceedings, improperly requires respondents to disclose their trial strategy, and infringes on the attorney work-product privilege.” The amendment was nevertheless adopted “substantially as proposed.”
Although the new amendments are generally a step in the right direction, they of course do not give respondents the same procedural protections as trials in federal court, and they fail to address the more fundamental criticisms of the Commission’s administrative forum. Commenters opposed the administrative forum on the grounds that the “Commission will choose to shield controversial cases from the full scrutiny of federal district and appellate courts” and that “conflicts of interest preclude the Commission from being perceived as a neutral arbiter.” However, the Commission determined that these comments, as well as a recommendation that the Commission create a procedure for respondents to remove certain cases to federal court, were “outside the scope of the proposed amendments” and did not address them.
Given Dodd-Frank’s expansion of the Commission’s penalty authority and the Commission’s increasing reliance on the administrative forum, the recent amendments are unlikely to quiet critics and curtail legal challenges. In Gupta v. SEC, in the face of the respondent’s Equal Protection claim of disparate treatment, Judge Rakoff denied the SEC’s motion to dismiss, rejecting the Commission’s arguments that Gupta’s claims were barred by sovereign immunity and that he had to exhaust administrative remedies. The Commission then withdrew its administrative proceeding and later sued Mr. Gupta in federal court. More recent challenges have fared less well. Federal appellate courts in the 2nd, 7th, 11th and D.C. Circuits — dealing principally with appointments clause and due process challenges to the Commission’s rules — have all recently held that such arguments must first be presented to the Commission before they can be considered by a federal court. But these jurisdictional setbacks do not extinguish — they merely delay — challenges to the constitutionality of the Commission’s administrative proceedings. Indeed, the D.C. Circuit should rule on the merits of one such challenge shortly, another development to watch for in this ongoing saga.