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Article: August 2016: Circuit Courts Align to Shield SEC Administrative Proceedings from Collateral Constitutional Attack

August 01, 2016
Business Litigation Reports

In response to the financial crisis of the late 2000s, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010. Previously the SEC could pursue civil penalties only against non-regulated entities and individuals in actions filed in federal district court. Dodd-Frank expanded the remedies available to the SEC in administrative proceedings. See Pub.L. No. 111-203, § 929P, 124 Stat. 1376, 1862-65. The intent was clear—make the SEC’s authority in administrative proceedings “coextensive with its authority to seek penalties in Federal court.” H.R. Rep. No. 111-687, at 78 (2010). Likely as a result of its increased success in administrative proceedings, the SEC has recently and dramatically increased the use of such proceedings. See Jean Eaglesham, SEC Wins with In-House Judges, Wall St. J., May 6, 2015. (From October 2010 through March 2015, the SEC prevailed in 90% of administrative proceedings while during the same time period its success rate in federal court was 69%. Whereas in 2012 55% of enforcement actions were filed administratively, in 2014 this rose to 78%.) These results have prompted numerous respondents in SEC administrative proceedings to file collateral Constitutional challenges in federal district court.

Overview of SEC Administrative Proceedings. The SEC may take one of two routes to enforce the federal securities laws in a civil proceeding. It can bring a civil action in federal district court or it can commence an administrative enforcement proceeding. See, e.g., 15 U.S.C. §§ 78u(d), 78u-2, 78u-3. Administrative actions commence when the SEC serves the respondent with an Order Instituting Proceedings (“OIP”). SEC administrative proceedings differ from federal district court actions in several important respects: the Federal Rules of Civil Procedure and Evidence do not apply in an administrative proceeding, nor does the respondent have the right to a jury trial. Instead, administrative proceedings are governed by the SEC’s Rules of Practice, 17 C.F.R. § 201.100 et seq., which severely constrain typical federal court discovery. For example, under the Rules of Practice, depositions occur at the Commission’s discretion, only after a finding that the witnesses will be unavailable to testify at the administrative hearing. Id. §§ 201.233(b), 201.234(a). Additionally, the Rules of Practice do not provide for typical document discovery, instead requiring the parties to request that the Administrative Law Judge (“ALJ”), whom the SEC typically designates to preside over an evidentiary hearing and render an initial decision, issue subpoenas. See id. §§ 201.360(a)(1), (b), 201.232. Administrative actions proceed relatively quickly and along a timeline set by the rules. See id. § 201.360(a)(2).

Once the ALJ renders an initial decision, either party may appeal to the SEC or the SEC may review it sua sponte. Id. §§ 201.410, 201.411(c). The SEC’s review authority is broad—it may “affirm, reverse, modify, set aside or remand for further proceedings, in whole or in part . . . and may make any findings or conclusions that in its judgment are proper and on the basis of the record.” Id. § 201.411(a). Absent appeal or sua sponte review, the ALJ’s initial decision becomes final. 15 U.S.C. § 78d-1(c). The SEC then must issue a final order. An adverse order allows the aggrieved party to seek review in the United States Court of Appeals either for the Circuit wherein he resides or has his principal place of business, or for the District of Columbia Circuit. 15 U.S.C. § 78y(a)(1). The aggrieved party may also request that the SEC stay enforcement of the order pending appellate review. 17 C.F.R. § 201.401. Section 78y provides a detailed framework for Circuit court review, whose exclusive jurisdiction is triggered upon filing. 15 U.S.C. § 78y(a)(1), (3). Section 78y then details how a final order of the Commission should be reviewed. Like the SEC, the Circuit court is granted broad authority and can “affirm or modify and enforce or [ ] set aside the order in whole or in part.” Id. § 78y(a)(3). While the court must accept the SEC’s factual findings which are supported by substantial evidence, the court may also remand the case to the SEC for additional findings. Id. § 78y(a)(4)-(5). Unless there was “reasonable ground” for failing to raise an objection to the final order before the SEC, the Circuit court is precluded from considering new objections. Id. § 78y(c)(1). The appellate court may also stay enforcement of the SEC’s order pending its review “to the extent necessary to prevent irreparable injury.” Id. § 78y(c)(2).

Circuit Court Decisions. Bebo v. SEC, 799 F.3d 765 (7th Cir. 2015), cert. denied, 136 S. Ct. 1500 (2016). The Seventh Circuit was the first appellate court to consider whether a federal district court had jurisdiction over constitutional claims brought by a respondent in an ongoing SEC administrative proceeding. In Bebo, the SEC commenced an administrative cease-and-desist proceeding against Bebo, alleging she violated federal securities laws by manipulating internal books and records, making false representations to auditors, and making false disclosures to the SEC. In response, Bebo asserted various affirmative defenses in her answer, including that the proceeding violated the equal protection clause, the due process clause, and Article II by interfering with President’s obligation to ensure faithful execution of the laws. Id. at 768. Rather than await a final order in the administrative proceeding, Bebo filed suit in federal district court alleging her same constitutional claims. Id. The district court granted the SEC’s motion to dismiss for lack of subject matter jurisdiction. Id.

On Bebo’s appeal, the Seventh Circuit explained that in order to “find congressional intent to limit district court jurisdiction, [it] must conclude that the claims at issue ‘are of the type Congress intended to be reviewed within th[e] statutory structure’” Id. at 769. To make that determination, the Seventh Circuit explained that courts look to the factors set forth in Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994), i.e. whether: (1) “a finding of preclusion could foreclose all meaningful judicial review,” (2) the suit was “wholly collateral to a statute’s review provisions,” and (3) the plaintiffs’ claims were “outside the agency’s expertise.” Id. (quoting Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477, 489 (2010)). Fatally for Bebo, the Seventh Circuit interpreted the Thunder Basin factors not according to what it saw as the “broader reading” of Free Enterprise, but the narrower, more recent interpretation in Elgin v. Dep’t of Treasury, 132 S. Ct. 2126, 2136-40 (2012). Bebo, 799 F.3d at 771. Seemingly putting all of the weight on the first factor, the Seventh Circuit affirmed the dismissal of Bebo’s Constitutional challenge in district court on jurisdictional grounds, holding that as a participant in an ongoing administrative action, Bebo had the opportunity to have her Constitutional objections addressed and, upon the conclusion of the administrative proceeding, “meaningful judicial review in an Article III court.” Id. at 774, quoting Elgin, 132 S. Ct. at 2137.

The Seventh Circuit’s decision is problematic because it affords no weight to the second Thunder Basin factor and does not substantively address the third factor at all. See Bebo, 799 F.3d at 773-774. Indeed, the court’s opinion that “the second and third Free Enterprise Fund factors, although relevant to the determination, are not controlling,” while the first factor is controlling, is not well supported. See id. at 774. Additionally, because of the way the court distinguished Free Enterprise, it presumably would find subject matter jurisdiction over these claims if an administrative proceeding had yet to be commenced. See id. (“The key factor in Free Enterprise Fund that rendered § 78y inadequate is missing here. To have her constitutional objections addressed, Bebo does not need to ‘select and challenge a Board rule at random’ . . . [s]he is already the respondent in a pending enforcement proceeding.”) The Supreme Court, however, denied Bebo’s petition for writ of certiorari. Bebo v. SEC, 136 S. Ct. 1500 (2016).

Jarkesy v. S.E.C., 803 F.3d 9 (D.C. Cir. 2015). Just over a month after the Seventh Circuit’s decision in Bebo, the D.C. Circuit “reach[ed] the same conclusion for many of the same reasons.” Jarkesy, 803 F.3d at 15. Days before his hearing in the administrative proceeding was to commence, Jarkesy filed an action in federal district court, alleging various Due Process and Equal Protection violations. Focusing on the availability of judicial review, the district court dismissed the case, reasoning Congress had implicitly precluded concurrent subject-matter jurisdiction in the district court. Id. at 12. Jarkesy appealed and the D.C. Circuit affirmed, concluding that Congressional intent requiring respondents to proceed exclusively through the statutory scheme of administrative and judicial review was “fairly discernible in the statutory scheme” and Jarkesy’s claims were of the type Congress intended to be reviewed within the statutory structure. Id. at 15-16.

For the D.C. Circuit, the SEC’s ability to choose the forum made the “fairly discernible” question relatively straightforward. In other words, if Congress gave the SEC the choice to pursue violations in either district court or administrative proceedings, respondents in administrative proceedings should not have the ability to countermand that choice by filing in district court. Id. at 17. Instead, the court focused its analysis on whether Jarkesy’s claims were of the type that Congress intended to be reviewed within the statutory structure. To make that determination, the court applied the Thunder Basin factors. Id. Unlike the Seventh Circuit, the D.C. Circuit believed all the various factors were “guideposts for a holistic analysis” and did not assess “whether the capacity for meaningful review would alone suffice to negate [district court] jurisdiction.” Id. at 22.

As to the first factor, whether Jaresky would be deprived of meaningful judicial review, the D.C. Circuit held he would not because he could present his Constitutional claims to the ALJ, and, if necessary, the SEC, and a federal appellate court. Id. at 19. Like the Seventh Circuit, the D.C. Circuit distinguished Free Enterprise Fund on the basis that Jaresky was already involved in a proceeding in which he could press his claims. Id. at 20. As to the second factor, whether the claims are wholly collateral, the court held they were not because they were the “vehicle by which” Jarkesy seeks to prevail in his administrative proceeding.” Id. at 23, quoting Elgin, 132 S.Ct. at 2139-40. As to the third factor, whether the claims were outside the SEC’s expertise, the D.C. Circuit pointed out that Elgin “clarified” that “an agency’s relative level of insight into the merits of a constitutional question is not determinative” and found no basis to conclude that Congress intended to exempt Jarkesy’s Constitutional claims from the administrative scheme. Id. at 28-29.

While the Seventh Circuit in Bebo seemed to imply that subject matter jurisdiction in the district court may exist if an administrative proceeding had yet to be commenced, the D.C. Circuit went a step further, explicitly stating that “[t]he result might be different if a constitutional challenge were filed in court before the initiation of any administrative proceeding (and the plaintiff could establish standing to bring the judicial action).” Id. at 23. The court, however, did not explain its statement. Similarly, the D.C. Court’s reasoning that the Constitutional claims are not wholly collateral, because the proceeding is ongoing and prevailing on those claims would end the proceeding, makes it difficult to understand whether any claims would ever be viewed as collateral.

Tilton v. SEC, No. 15-2103, 2016 WL 3084795 (2d Cir. June 1, 2016). The SEC initiated an administrative proceeding against Tilton and certain investment firms for alleged violations of the Investment Advisers Act. Tilton, 2016 WL 3084795, at *2. Two days later, Tilton filed suit in federal district court alleging constitutional violations, including that the ALJ conducting the proceeding was impermissibly insulated from Presidential removal and not appointed in accordance with the Appointments Clause. Id. The district court dismissed for lack of subject matter jurisdiction. Id. at *1. Tilton then appealed to the Second Circuit. A divided Second Circuit affirmed the district court’s dismissal, holding that Tilton must await the SEC’s final order before a federal court had jurisdiction to hear his claims. Id. at *11.

As with the Seventh and D.C. Circuits, the Second Circuit applied the Thunder Basin factors to determine whether the claims were of the type that Congress intended to be reviewed within the statutory structure. Id. at *3. As to the first factor, meaningful judicial review, the court found that post-proceeding judicial review did not deprive Tilton of meaningful review of his claims and any attendant financial or emotional costs are “simply the price of participating in the American legal system.” Id. at *6. As to the second factor, whether the Appointments Clause claim was “wholly collateral” to the administrative proceeding, the court held that, because Tilton raised it as an affirmative defense, it was “procedurally intertwined” with the administrative proceeding. Id. at *8. As to the third factor, whether the claim was outside the SEC’s expertise, the court held that while a “close question,” Tilton’s claim did not fall outside the SEC’s expertise because the SEC “routinely considers” accompanying statutory claims that could be resolved in Tilton’s favor, thus mooting the Constitutional questions.

In dissent, Judge Droney took issue with the majority’s application of each of the Thunder Basin factors. First, he pointed out that forcing defendants to conclude an administrative proceeding before bringing a constitutional challenge in federal court is not truly meaningful review because “they will already have suffered the injury that they are attempting to prevent.” Id. at *17. Second, Judge Droney argued the majority misinterpreted Thunder Basin, Free Enterprise, and Elgin because under the majority’s interpretation, no claim could be “wholly collateral” “as long as the claim could somehow serve to end administrative proceedings in a [respondent’s] favor.” Id. at *14. Finally, Judge Droney criticized the majority’s interpretation of the “expertise” factor because “as long as a proceeding is ongoing . . . [that] factor must weigh against jurisdiction—because any time a proceeding has commenced there is of course some possibility that a plaintiff may prevail on the merits.” Id. at *15.

Hill v. SEC, Nos. 15-12831, 15-13738, 2016 WL 3361478 (11th Cir. June 17, 2016). In consolidated cases, the Eleventh Circuit recently joined other circuits in holding that federal district courts do not have subject matter jurisdiction over constitutional challenges from respondents facing ongoing or prospective SEC administrative proceedings. Hill, 2016 WL 3361478, at *13. The SEC commenced an administrative proceeding against Hill for unlawfully profiting from non-public information regarding a corporate merger. Id. at *2. After the SEC scheduled a hearing before an ALJ, Hill filed motions to dismiss in the administrative proceeding, claiming various Constitutional violations, including that the proceeding violated the removal protections of Article II, the non-delegation doctrine under Article I, and his Seventh Amendment right to a jury trial. Id. at *3. While the ALJ denied Hill’s motion, he concluded he lacked authority to rule on the constitutionality of the Exchange Act. Id. Hill then sought relief in the federal district court—his complaint repeated his prior arguments and added claim that the ALJs’ appointment violated the Appointments Clause. Id. The district court judge granted Hill’s motion and a similar motion by investment adviser Gray Financial, which had preemptively filed its Constitutional claims in district court before the SEC commenced an administrative proceeding. Id. at *3-4. In both cases, the district court found it had subject matter jurisdiction to hear the claims and that ALJs’ appointments violated Article II. Id. at *4.

The SEC appealed the district court rulings and the 11th Circuit vacated the injunctions and instructed the district court to dismiss both cases for lack of jurisdiction. Id. at *13. The 11th Circuit relied heavily on “the detail in § 78y [which] indicates that Congress intended to deny aggrieved parties another avenue for review,” to find it was “fairly discernible,” that Congress intended the respondents’ claims to be resolved exclusively in the administrative proceeding, the final order from which could then be appealed to a federal appellate court. Id. at*6. Like Bebo, the 11th Circuit emphasized the importance of first Thunder Basin factor, opportunity for meaningful judicial review. Id. at *8. The 11th Circuit tracked the reasoning of Bebo, Jarkesy, and Tilton, finding that enduring an unwanted administrative proceeding is not an irreparable injury such that subsequent judicial is not meaningful. Id. Furthermore, because Hill was already a respondent in the administrative proceeding, he did not need to initiate a proceeding just to test his claims. Id. at *10. In closing the timing loophole which the prior Circuit cases arguably left open, the 11th Circuit held it did not matter that Gray filed her action before the SEC commenced an administrative proceeding against her, reasoning that because the SEC intended to do so, she had ample opportunity for meaningful review of her claims. Id. The 11th Circuit gave only brief consideration to the second and third Thunder Basin factors, holding, like the other Circuits, that the SEC’s expertise was implicated because resolution of the securities violations would obviate the need to reach the Constitutional questions. Id. at *11-12. The court then examined the wholly collateral factor and reasoned that because the Constitutional claims were not a vehicle by which they seek to prevail on the merits, the claims could be characterized as wholly collateral, but it did not matter in the face of the conclusion that administrative proceedings guarantee meaningful judicial review. Id. at *12-13.

Conclusion. Although the D.C. Circuit may soon decide a fully ripe Constitutional challenge to SEC administrative proceedings, Lucia v. SEC, No. 15-1345 (D.C. Cir., argued May 13, 2016), because four Circuit courts have held that federal district courts lack jurisdiction to hear Constitutional challenges to SEC administrative proceedings, it is unlikely the Supreme Court will consider the jurisdictional issue anytime soon, especially considering it denied certiorari in Bebo. As a result, there will likely be increasing pressure on respondents to SEC administrative proceedings to settle rather than endure the disruption and expense of litigating fully just to gain access to federal court at the end of the road. Accordingly, it is imperative to seek the advice of counsel as soon as it appears the SEC may commence an administrative proceeding.