The Supreme Court ruled on Thursday that administrative law judges appointed by the Securities and Exchange Commission are “not mere employees,” putting into dispute their roles and rulings involving private equity firms and investment advisors.
SEC administrative law judges are officers of the United States, the Supreme Court said in its 7-2 decision, which means they must go through a proper hiring procedure known as the Appointments Clause and be appointed by either the president, a court of law or head of the agency. All five of the sitting judges did not go through this process.
The decision comes from an appeal by television and radio personality Raymond Lucia, who was fined by the SEC in 2013 for violating rules. The agency filed a case against him for marketing a retirement savings strategy that it said was used in misleading slideshow presentations to deceive prospective clients. The administrative law judge presiding over the case, Cameron Elliot, imposed penalties including a $300,000 fine and a lifetime ban for Lucia, a former investment advisor, from the investment industry.
In his appeal Lucia argued that the ruling against him was invalid because Elliott was not constitutionally appointed and therefore lacked the authority to do the job. The hiring of Elliott and the four other judges was left to SEC staff members. By showing that these judges were non-officer employees, Lucia presented the case that they did not have the right to make rulings over administrative proceedings such as his.
The decision brings into question the legitimacy of administrative law judges’ decisions in previous cases. Just this week, a judge ruled against investment advisor Lawrence E. Penn, III for violating the anti-fraud provisions of the federal securities laws and barred him from the securities industry.
Penn was accused of engaging in a fraudulent scheme between March 2010 and October 2013 to misappropriate around $9 million from a private equity fund managed by CM Growth Capital Partners which he used for his business and personal expenses. In 2015, he was ordered to pay almost $8.4 million in restitution and was sentenced to a prison term of two to six years.
One lawyer, who served as a senior officer in the SEC’s Office of Compliance Inspections and Examinations, said the agency will find a way to retain its administrative law judges.
“The SEC’s administrative court is unlikely to disappear,” said Ken Joseph, a managing director in Duff & Phelps’ Disputes and Investigations practice in New York. “I expect the SEC will take steps in the short-term to appoint its ALJs in a manner that will pass constitutional muster. It is unclear whether the steps taken by the Commission last November to ratify post-hoc the appointments will withstand constitutional scrutiny. That question was not addressed by the Lucia Court. While it seeks to sort out the impact of, and its response to, Lucia it is possible that the Commission may choose the federal district court forum for at least some of the estimated 20 percent of litigated cases that it previously filed in the in-house courts.”
He also said that in terms of pending proceedings, all pending administrative proceedings that were set for hearing before a SEC ALJ, including those involving private equity respondents, will be delayed for a minimum of 30 days.
Regarding previous rulings, Joseph said the Supreme Court did not specifically address what would, or should, happen in prior litigated administrative actions, especially those in which the respondent did not raise the constitutional issue relating to the appointment of the administrative law judges. However, he said, using the rationale that Lucia found the judge selection process used by the SEC to be unconstitutional, respondents who suffered adverse decisions in civil administrative proceedings that were heard initially by an administrative law judge may find the precedent they need to argue for a re-hearing, or even dismissal, of the Division of Enforcement’s allegations.
“That worse-case scenario for the SEC would open a floodgate and probably cause the Commission to divert significant litigation resources if it elects to re-try those cases. These prior rulings by SEC ALJs may have levied disgorgement, penalties, and industry bars upon respondents,” Joseph said.
The Duff & Phelps managing director said the majority on the Supreme Court was silent on the impact on administrative law judges in the executive branch who have been selected in a manner that the court found to be unconstitutional in the Lucia case, and who perform similar functions to these judges at the SEC. But he advised that private equity advisors with actions pending or completed before other federal agencies should evaluate whether the holding can be extended to invalidate those administrative law judges as well.
“One report indicated that ALJs employed by some 25 federal agencies may be impacted,” Joseph said.
An SEC spokesman said in an email that Chairman Jay Clayton “is reviewing the opinion and expects to consult with his fellow Commissioners to determine appropriate next steps.”
This story has been updated to include comments from Duff & Phelps’ Ken Joseph.