SEC on defensive following setback on use of hearings

An impressive yearlong enforcement winning streak by the Securities and Exchange Commission could come to a screeching halt as the securities watchdog finds itself being forced to defend a preference for in-house administrative hearings over court action.

SEC Chairwoman Mary Jo White is feeling the heat personally. On June 2, Sen. Elizabeth Warren, D-Mass., sent a 13-page letter criticizing Ms. White for “extremely disappointing leadership” on several fronts, including granting waivers to companies found guilty of criminal violations that violate securities or other laws, allowing them to continue to serve as money managers and to issue securities.

The SEC's authority to file enforcement cases through administrative proceedings is not new, but it became much more attractive after the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 added the authority to impose substantial monetary penalties. Aggressive use of that option since 2014 seemed to be working for the SEC, until enough firms on the receiving end of administrative judgments decided to fight back and attack the process itself, arguing it is unconstitutional because of the way the administrative judges are appointed.

A pivotal decision came June 8 from U.S. District Judge Leigh Martin May in Atlanta, who issued an injunction on the SEC's administrative case against Charles Hill, an Atlanta real estate developer accused of insider trading, saying that he had a “substantial likelihood of success” of making the unconstitutional argument stick because the in-house judges are essentially hired by the SEC instead of following the U.S. Constitution's appointments clause. “This likely appointment clause violation goes to the validity of the (administrative) proceeding,” Ms. May said.

One firm particularly heartened by the Hill decision is institutional timber manager Timbervest LLC, Atlanta, which is also challenging the constitutionality of the SEC process in a case recently assigned to Ms. May. In August 2014, an SEC administrative law judge ruled against the firm and its executives in a case alleging improper fees from cross trades of land from a separate account managed for the BellSouth Corp. pension fund (now part of the $45.2 billion AT&T Inc. pension fund, Dallas) and a Timbervest commingled fund. Timbervest officials, who were ordered to disgorge $1.9 million plus interest, are fighting to have a final SEC decision stopped and now also are challenging the entire process on constitutional grounds.

Timbervest officials “felt they almost had no choice,” said Stephen D. Councill, Timbervest's defense attorney who is a partner in Atlanta law firm Rogers & Hardin LLP. “The (SEC) success rate is so extraordinary now, particularly compared to how they're faring in federal court. The (administrative law judge) was wrong in so many ways, and having gone through it you recognize it,” said Mr. Councill, who headed the SEC's Atlanta enforcement office until 2003.

“The reason you have appointments is to have some accountability. When we saw the appointments clause argument (from the Hill case), it seemed extremely compelling. It definitely looks like things are changing,” Mr. Councill said.

SEC lawyers appealed Ms. May's decision on June 24, and asked the court to lift the injunction, arguing that it “interferes with the SEC's ability to enforce” securities laws.

The potentially far-reaching consequences of her ruling were not lost on lawyers at the Department of Justice, who will represent the SEC in similar challenges brought by Houston hedge fund manager George Jarkesy Jr. in the U.S. Court of Appeals for the District of Columbia; New York private equity firm Patriarch Partners and CEO Lynn Tilton in the U.S. District Court in New York; and Gray Financial Group in U.S. District Court in Atlanta, among others. The Hill case was “wrongly decided,” Justice Department lawyers said in a letter to the judge assigned to the Patriarch case.

The Robare Group, a Houston-based money manager, celebrated its own victory against the SEC in June, after an administrative law judge dismissed charges of inadequate disclosure to investors. In his ruling, administrative judge James Grimes cited one witness who called the agency's idea of adequate disclosure “a moving target” that could be fixed with better guidance.

A perceived lack of disclosure by the SEC itself on how it chooses enforcement venues has prompted several former SEC enforcement chiefs to openly criticize the current regime, which until May 2015 did not have written guidance on the process. Still, said Robare Group's attorney Alan Wolper of law firm Ulmer & Berne LLP in Chicago, “I don't think they'll change until they have to change.”