SEC Reform of In-House Trials Gets Lukewarm Reception

The in-house administrative hearings at the Securities and Exchange Commission are getting lots of attention from the outside these days.

Facing lawsuits and other complaints that its administrative proceedings (known more informally as “APs”) are stacked against defendants, the SEC is mulling numerous changes to give the accused more ability to defend themselves. The proposals have received lukewarm reception at best.

Securities law does authorize the SEC (and other federal agencies) to try some disputes internally, rather than further clog the already overburdened federal courts. Recently, however, the SEC has expanded its use of the proceedings to more complex cases—insider trading and accounting fraud, for example—that historically were resolved in court. That has led to criticism about the truncated nature of proceedings, discovery, and evidence rules that are too loose in some regards and overly restrictive in others, and the sense that an in-house forum works against defendants.

For the SEC to consider changing its rules, even minimally, is somewhat welcome news to those in the securities industry. “The proposed amendments certainly represent steps in the right direction,” says Alan Wolper, a partner at law firm Ulmer & Berne and co-chair of the securities litigation practice. “The proposed amendments do not, however, come close to addressing all the issues that administrative proceedings create.”

The proposed rules will now be open to a 60-day comment period, following their publication in the Federal Register.

The most substantive rule change would extend the deadline by which an administrative law judge must issue a decision. Currently, judges must issue an opinion within 300 days from when the SEC files the order instituting proceedings, and the hearing must occur within four months of the SEC initiating the proceeding. “In a complicated case where the staff produces several million pages of documents, it can be a real burden to try to get that material reviewed in that time period,” says Thomas Gorman, a partner with law firm Dorsey.

The proposed rules would extend the four-month period to eight months, but that still may not be enough time for complex cases. “In a lot of cases that’s sufficient, but when you’re looking at more complex cases involving a larger number of respondents, I’m not sure that eight months is going to be enough,” says Molly White, a partner at law firm McGuire Woods.

“The proposed amendments certainly represent steps in the right direction to cure some of the drawbacks that respondents in administrative proceedings face that defendants in federal court do not.”
Alan Wolper, Partner, Ulmer & Berne

The deadline for filing an initial decision also would be amended, starting from the time that the post-hearing briefing has been completed, rather than from the date of the SEC’s order instituting proceedings. “This modification would divorce the deadline for the completion of an initial decision from other stages of the proceeding,” the proposed rule states.

The proposed rules also would allow defendants to take sworn testimony of witnesses, instead of relying on whatever witness testimony the SEC chooses to pursue in its investigation. Currently, defendants may ask permission to take a deposition only if the witness will be unable to attend or testify at the hearing. Allowing for discovery depositions would constitute “a dramatic improvement over the current procedure,” Wolper says.

The number of allowable depositions would be limited. In cases involving a single respondent, the SEC and defense each would be allowed three depositions, “which doesn’t seem so unreasonable, especially if the case is not terribly complicated,” White says.

Cases involving multiple respondents, however, would allow a maximum of five depositions per side, and that is raising hackles. “Five depositions is a very arbitrary and limited number of depositions when you have no idea who may have the most pertinent information for your defense,” says Trace Schmeltz, a partner in white-collar defense at law firm Barnes & Thornburg.

Others argue that it does little in the way of evening the playing field between the SEC and defendants. “To offer up the opportunity to take a few limited depositions before the administrative hearing, when the SEC also has the opportunity to take additional depositions, isn’t about giving the respondents a fair opportunity,” says Kit Addleman, a partner at law firm Haynes and Boone. “It’s really preserving the unbalanced playing field that currently exists.”

These “hard and fast rules” concerning trial dates and depositions also don’t account for differences in the types of cases and the amount of documents and witnesses involved—all factors that a federal district court judge has an opportunity to consider before setting something for trial, Addleman says.

Hearsay evidence

Another proposed change aims to create stricter limits on when hearsay evidence may be used in an administrative proceeding. The proposed rules clarify that hearsay may be admitted if it is “relevant, material, and bears satisfactory indicia of reliability so that its use is fair.”

Defense lawyers want such evidence banned altogether, as it is in federal courts. “The SEC has now codified something that administrative law judges have done for years, which is admit evidence just because it seems kind of reliable,” Schmeltz says.

Gorman is also disappointed that the SEC doesn’t use the Federal Rules of Evidence to govern hearings. Right now, the agency can introduce multiple layers of hearsay without cross-examination, “which really makes trying one of these cases very difficult,” he says.

Appeals process

The SEC has also proposed to streamline the appeals process. Rather than having to provide all specific findings and conclusions of the initial decision they find objectionable, defendants would only need to provide “a summary statement of the issues presented for review,” limited to three pages, avoiding a lengthy documentation process.

The proposed rules would set a deadline of up to 10 months for the SEC to decide on appeals, addressing concerns about potential delays. Only after that review can defendants try their luck in court.

Recent case law

Nothing about the proposed rule changes address the elephant in the room: that appeals of an AP decision are still heard by SEC staff, “the very individuals who authorized the issuance of the complaint in the first place,” Wolper says.

Two federal court cases—Duka v. Hill in the Southern District of New York, and Hill v. SEC in the Northern District of Georgia—recently have issued preliminary injunctions halting ongoing SEC administrative proceedings on the grounds that the appointment of the SEC’s administrative law judges are an unconstitutional violation of the Appointments Clause, which provides that “inferior officers” may be appointed only by the president, the courts of law, or the heads of departments. Both cases are currently on appeal.

On Sept. 29 an appeals court in Washington issued a ruling to the contrary in the case Jarkesy v. SEC, upholding the SEC’s authority to use administrative proceedings. The decision resulted from a lawsuit the SEC filed in 2013 against hedge fund manager George Jarkesy over allegations that he defrauded investors.

In that case, Jarkesy argued that the SEC’s internal process infringed on his constitutional rights. The district court denied his request, ruling that it lacked authority to review the case. The U.S. Court of Appeals for the District of Columbia affirmed that decision. “Should the agency’s final order be adverse to him, Jarkesy can then raise his challenges in a petition for review to a court of appeals,” the court wrote in a unanimous decision.

The whole fairness issue raised by administrative proceedings isn’t just “squawking” among the SEC and defendants, Schmeltz says; it affects every company and the entire securities industry. His point: “If the SEC is going to hand-pick a forum to bring cases, it ought to be the case that everyone who is subject to the SEC’s jurisdiction—every company, every executive, every broker-dealer—ought to take a stand and ensure that that forum will afford defendants the most fair proceeding possible.”