Client Alerts

Federal Court Chips Away at SEC’s Use of In-House Administrative Proceedings Against Insider Trading Defendants

Client Alerts | June 11, 2015 | Securities and Corporate Finance | Hedge Funds

On June 8, 2015, U.S. District Judge Leigh Martin May handed down an important decision affecting the SEC’s practice of bringing insider trading enforcement actions in the form of in-house administrative proceedings instead of civil court actions. In a 45-page opinion, Judge May enjoined the SEC from continuing with an ongoing administrative proceeding on the basis that the SEC’s current process for appointing its administrative law judges (ALJs) is “likely unconstitutional.”

On May 19, 2015, Charles L. Hill, Jr., the defendant accused of insider trading in the administrative proceeding, filed a complaint in the U.S. District Court for the Northern District of Georgia, asking the federal court to declare the administrative proceeding unconstitutional, and to enjoin the administrative proceeding from occurring until the Court could issue a ruling on the merits. Hill argued that the administrative proceeding was unconstitutional because: (1) Congress’s delegation of authority to the SEC to pursue cases before ALJs violates the delegation doctrine in Article I of the Constitution; (2) Congress violated his Seventh Amendment right to a jury trial by allowing the SEC to pursue charges in an administrative proceeding; (3) the ALJ’s appointment violates the Appointments Clause of Article II because he was not appointed by the President, a court of law, or a department head; and (4) the administrative proceeding violates Article II of the Constitution because ALJs are protected by two layers of tenure protection.

The Court rejected Hill’s argument that Congress’s delegation of authority to the SEC to pursue cases before ALJs violates Article I, holding that “[w]hen the SEC makes its forum selection decision, it is acting under executive authority and exercising prosecutorial discretion.” Hill’s argument that his Seventh Amendment right to a jury trial was violated was rejected on the grounds that the administrative proceeding involved a “public right” and that “Congress has the right to send public rights cases to administrative proceedings.”

Despite rejecting Hill’s first two constitutional arguments, the Court found that his Appointments Clause argument had a likelihood of success on the merits. The Appointments Clause in Article II of the Constitution states that:

[The President] shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

After determining that the ALJs qualified as “inferior Officers” under the Appointments Clause, the Court found that the SEC’s procedure for appointing the ALJs likely violated the Appointments Clause because the ALJs were not appointed by either the President, the Judiciary, or the SEC Commissioners. Rather, the ALJs are “hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions, and the Office of Personnel Management.”

The Court concluded that Hill would be irreparably harmed if forced to litigate his case before an ALJ, whose appointment was likely unconstitutional. The Court also found that the SEC would not be prejudiced by the injunction because “the SEC is not foreclosed from pursing [sic] Plaintiff in federal court or in an administrative proceeding before an SEC Commissioner, and thus any small harm which it might face could be easily cured by the SEC itself.” Judge May went on to hold that the SEC was preliminarily enjoined from conducting Hill’s administrative proceeding “before an Administrative Law Judge who has not been appointed by the head of the Department.”

The SEC’s administrative proceedings have become highly controversial in recent years, as many defendants in the proceedings have complained that the process is inherently unfair. Among the concerns raised by defendants in the administrative proceedings are that discovery is limited, depositions are generally not permitted to be taken by defense attorneys, and there are no juries. Perhaps the most significant criticism is that both the judge and the prosecutor are employees of the SEC, and appeals can be taken only directly to the SEC commissioners. According to the Wall Street Journal, the SEC prevailed against 90% of defendants in contested administrative proceedings from October 2010 to March 2015, a significant difference from the SEC’s 69% win rate in federal court over the same period.

This case potentially represents a significant breakthrough for insider trading defendants in SEC administrative proceedings. Although other defendants have asserted constitutional claims in lawsuits against the SEC, this is the first time a federal court has granted an injunction to halt an ongoing SEC administrative proceeding based on a constitutional challenge. The decision will likely lead to insider trading defendants in other SEC administrative cases seeking to stay their cases on similar grounds, and even to unsuccessful defendants in past proceedings seeking to challenge the decisions in those cases.

Notably, this case does not necessarily sound the death knell for the SEC’s practice of bringing enforcement actions as administrative proceedings before ALJs. As even Judge May recognized, the constitutional violation arising from the ALJ’s appointment “could easily be cured by having the SEC Commissioners issue an appointment or preside over the matter themselves.” Thus, it remains to be seen whether constitutional challenges asserted by Hill and other insider trading defendants will succeed in the long run in upending the entire ALJ regime rather than merely causing temporary roadblocks for the SEC.