In The Shadow Of Lucia: The Uncertain Future Of SEC Administrative Proceedings

• Published date: 23 June 2022
• Subject Matter: Corporate/Commercial Law, Consumer Protection, Government, Public Sector, Corporate and Company Law, Constitutional & Administrative Law, Securities, Dodd-Frank, Consumer Protection Act
• Law Firm: Arnold & Porter
• Author: Ms Veronica Callahan, Ryan Hartman, Daniel Hawke, John Hindley, Matt Hudson, Allon Kedem, Joshua Martin, Jane Norberg, Christian D. H. Schultz and Michael Trager

The US Securities and Exchange Commission (SEC or Commission) is an independent agency that investigates potential violations of the federal securities laws. At times, it also acts as both prosecutor and adjudicator when it enforces such laws in administrative proceedings. In recent years, respondents have successfully challenged the constitutionality of certain aspects of SEC administrative proceedings-and, in recent weeks, noteworthy developments in two cases could significantly affect whether the Commission will be able to continue instituting and litigating enforcement actions in such proceedings. This Advisory covers the background of SEC administrative proceedings, discusses the recent case developments, and identifies key takeaways and open questions that will need to be answered before the fate of SEC administrative proceedings can be decided.

Background of SEC Administrative Proceedings

The debate over the appropriate functions of independent agencies, including the SEC, is nothing new. It dates to the 1930s, when many of these agencies were created, and has focused on the varying powers delegated by Congress. As discussed in a Report on Regulatory Agencies issued in 1960 by James Landis, who had served as the second Chair of the SEC, one of the reasons for this delegation was a belief that "the problems in a particular area were so manifold and complex that the Congress simply had neither the time nor the capacity to handle them" through the legislative process. Moreover, according to Landis, the delegation of adjudicatory powers to the regulatory agencies "stemmed from the conviction that the issues involved were different from those that theretofore had been traditionally handled by courts and thus were not suited for judicial determination." As a result, given that regulatory agencies possessed highly specialized subject matter expertise, Congress viewed them as being best positioned to engage in rulemaking, promulgate policy, investigate and prosecute violations, and adjudicate enforcement matters relating to the industries they regulated.

Over the years, these wide-ranging powers caused what Landis called "problems common to all the regulatory agencies." As Landis described, one of the earliest problems was "the combination of prosecuting and adjudicatory functions within the same agency," which "eventually led to the passage of the Administrative Procedure Act of 1946 with its emphasis upon the internal separation of these functions within the agency and the granting of some degree of independence to the hearing examiners." As for the SEC, this also meant that Congress initially limited the agency's adjudicatory powers as well as the enforcement remedies available to it. In this regard, in its early years, the SEC could seek injunctive relief in the federal district courts or it could institute administrative proceedings-but such proceedings could only be brought against regulated entities (such as broker-dealers) in an effort to seek remedial sanctions (such as trading suspensions).

As time passed, however, Congress granted the Commission more and more authority (and available remedies) in administrative proceedings, often in response to securities scandals and adverse market events. For example:

• Expansion of authority after the Treadway Commission's Report on Fraudulent Financial Reporting and stock market crash of 1987. The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 authorized the Commission to use administrative proceedings to (i) issue cease-and-desist orders against anyone who is found to have violated the federal securities laws and (ii) impose civil money penalties against regulated entities and their associated persons.
• Expansion of authority after the Enron and WorldCom scandals and tech wreck of 2000. The Sarbanes-Oxley Act of 2002 authorized the Commission to use administrative proceedings to bar individuals from serving as officers or directors of public companies if such individuals are found to have violated the scienter-based antifraud provisions of the federal securities laws.
• Expansion of authority after the Madoff scandal and financial crisis of 2008. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) authorized the Commission to use administrative proceedings to impose civil money penalties against anyone who is found to have violated the federal securities laws, meaning that the SEC's ability to assess penalties in administrative proceedings is no longer limited to regulated entities and their associated persons.

As a result of these changes, Congress has all but obliterated the important distinctions that historically existed between the SEC's federal district court actions and administrative proceedings. The Commission now has essentially the same menu of enforcement tools if it brings an administrative proceeding before one of its own Article I ALJs as it would if it were to bring the case as a federal district court action before an Article III judge. There remain some minor differences-for example, the Commission issues cease-and-desist orders in administrative proceedings while it seeks injunctions in federal court actions-but, under the current legislative framework, civil money penalties, disgorgement, pre-judgment interest, officer and director bars, and other equitable relief are all available to the Commission, regardless of the forum selected.

The SEC's Use of Its Expanded Authority and the Resulting Backlash

As the SEC was granted broader authority in administrative proceedings, it took advantage of its new powers. The first major signal that the Commission might shift to using administrative proceedings more frequently (and forcefully) was its insider trading action against Rajat Gupta. Despite the fact that the SEC historically had sued alleged insider traders in federal district court, in March 2011, the Commission issued an order instituting administrative proceedings against Gupta, which alleged that he had violated the antifraud provisions of the federal securities laws by engaging in insider trading. This was a wake-up call to the securities bar and others in the industry, as it was a clear departure from the Commission's prior practice. In response to the action, Gupta sued the SEC in federal district court, alleging that the agency deprived him of equal protection under the law given that it had sued a number of other individuals involved in the alleged insider trading scheme in court rather than instituting administrative proceedings against them. In response to Gupta's lawsuit, the Commission, on its own accord, dismissed the administrative proceeding against him in August 2011-but then, less than three months later, the SEC filed a complaint against Gupta in federal district court and litigated that case to a judgment.

Although the Commission reversed course in the Gupta action, it was not deterred from bringing an increasing number of enforcement actions as administrative proceedings, and the SEC staff was open about its intention to do so. For example, in 2013, an article in the New York Times quoted Andrew Ceresney (then the Co-Director of the SEC's Division of Enforcement) as stating, "Our expectation is that we will be bringing more administrative proceedings given the recent statutory changes." And the agency did just that. The number of SEC administrative proceedings rose significantly beginning in 2012, and, at the same time, there was a corresponding drop in enforcement actions brought in federal court.¹ Then, in 2014, an article in the Wall Street Journal quoted a senior SEC enforcement official as calling the more frequent use of administrative proceedings "the new normal" for the agency. That same year, the SEC doubled down on its shift to bringing more actions administratively when it added two new ALJs and three new attorneys to its Office of Administrative Law Judges and announced that these "additions will nearly double the size of the office."

This dramatic shift was not without controversy. Critics primarily argued that the Commission had a home court advantage when litigating before its own ALJs. There also was public outcry about the inherent unfairness of the fact that (i) respondents are required to appeal any adverse decision by an ALJ to the Commission itself before having an opportunity to be heard by a federal appellate court, and (ii) once a Commission opinion is appealed, the appellate court must apply deference by assuming the administrative decision approved by the Commission was correct unless unreasonable. One vocal critic of the SEC's shift was Judge Jed S. Rakoff of the US District Court for the Southern District of New York, who gave a keynote address at the November 2014 PLI Securities Regulation Institute. In his address, Judge Rakoff provided a short history of SEC administrative proceedings and stated:

In short, what you have here are broad antifraud provisions, critical to the transparency of the securities markets, that have historically been construed and elaborated by the federal courts but that, under Dodd-Frank, could increasingly be construed and interpreted by the SEC's administrative law judges if the SEC chose to bring its more significant cases in that forum. Whatever one might say about the SEC's quasi-judicial functions, this is unlikely, I submit, to lead to as balanced, careful, and impartial interpretations as would result from...