Alex Kon Challenges SEC Administrative Law Judges
The SEC’s Use of Administrative Law Judges After Dodd Frank
Following passage of the Dodd-Frank Act in 2010, the Securities and Exchange Commission (“SEC”) began making greater use of its in-house administrative judges to hear enforcement cases. Between September 30, 2013 and September 30, 2014, it filed 57 percent of its actions in federal district court, and 43 percent with its own five administrative law judges (“ALJs”).
The increased use of ALJs quickly came under fire; critics pointed out that defendants are at a disadvantage when the SEC plays the roles of prosecutor, judge, and jury. In a November 2014 speech before the American Bar Association, then-Enforcement Director Andrew Ceresney defended the practice, pointing out that the agency had been using administrative proceedings for decades, and that many of the cases in question involved complex securities issues. A greater number of such cases was now being brought because:
Until 2010, while we could proceed against unregistered persons in administrative proceedings, the relief that we could obtain against them was limited. In the Dodd-Frank Act, however, Congress provided us authority to obtain penalties in administrative proceedings against unregistered parties comparable to those we already could obtain from registered persons.
Before that, penalties against unregulated entities or individuals were only available in district court. That legislative change allows us to obtain many — though not all — of the same remedies in administrative proceedings as we could get in district court. And so what we are doing now is simply making use of the administrative forum in cases where we previously could only obtain penalties in district court.
That meant the SEC was no longer limited to seeking monetary penalties in administrative court from people like brokers and investment advisers; it could expand its scope to include cases involving insider trading and investment fraud.
In his defense, Ceresney noted that the administrative forum might be considered preferable by both parties to a case because actions are decided quickly. ALJs usually have only 300 days from the initiation of a matter to produce an initial decision. Cases heard in district court can go on for years. The ALJs themselves are “specialized factfinders” who have expert knowledge of the securities laws, and a great deal of experience in the kinds of cases that appear before them. He added: “ALJs call it like they see it, and I note that we have lost some significant proceedings before ALJs in the last few years. Further, I would challenge anyone to identify a case in which an ALJ erroneously ruled for us where the Commission did not reverse the decision.”
The same month, Judge Jed Rakoff of the United States District Court for the Southern District of New York went after the agency in a speech dramatically titled, “Is the S.E.C. Becoming a Law Unto Itself,” in which he argued that the expansion of its internal enforcement powers was a dangerous example of “administrative creep.” Rakoff objected that administrative proceedings “involve much more limited discovery than federal actions, with no provision whatsoever for either depositions or interrogatories” and that “at the hearing itself, the Federal Rules of Evidence do not apply and the S.E.C. is free to introduce hearsay.”
His more fundamental concern, however, was that an increased use of administration proceedings “hinders the balanced development of the securities laws.” Over the years, district court judges have, in their decisions, defined, refined, and interpreted those laws in ways that have helped form a general consensus about what is and is not legal. The cases were heard before juries, and could be appealed. Cases decided by ALJs can also be appealed, though any appeal must initially be heard by the SEC commissioners. As Rakoff says:
…in the case of administrative decisions that have been formally approved by the S.E.C., such decisions, though appealable to the federal courts of appeals, are presumed correct unless unreasonable. In other words, while the decisions of federal district courts on matters of law are subject to de novo review by the appellate courts, the law as determined by an administrative law judge in a formal administrative decision must be given deference by federal courts unless the decision is not within the range of reasonable interpretations.
He concluded the “administrative creep” in question was unfair to respondents, not good for the SEC itself, and not good for the “impartial development of the law in an area of immense practical importance.”
A few months later, the U.S. Chamber of Commerce issued a detailed report echoing Judge Rakoff’s concerns.
Challenges to the SEC
This issue is not important only to the SEC. Other government agencies also use administrative judges; throughout the system, there are about 1700 of them. Challenges to the SEC’s decision to try complex securities cases in administrative forums, if successful, could have wide-reaching consequences. In September 2015, the New York Times reported on the status of appeals already brought in connection with a handful of SEC administrative handful of SEC administrative proceedings. Results were mixed.
A few months earlier, Atlanta District Court Judge Leigh Martin May granted an injunction halting an administrative proceeding against Charles Hill, whom the agency had charged with illegal insider trading. May ruled that the issue was, as Hill claimed, constitutional, and that the district court had subject matter jurisdiction of the case for that reason. Hill was not challenging the SEC’s decision in the case, because no decision had yet been made; he was “challenging whether the SEC’s ability to make that decision was constitutional.”
Hill further contended that the ALJ’s appointment violates the Appointments Clause of Article II of the Constitution because he was simply hired by the SEC’s Office of Administrative Law Judges, not appointed by the president, the courts, or the SEC Commission; and that “the ALJ’s two-layer tenure protection violates the Constitution’s separation of powers, specifically the President’s ability to exercise Executive power over his inferior officers.” According to May, “[b]oth of Plaintiff’s arguments depend on this Court finding that the ALJ is an inferior officer who would trigger these constitutional protections.”
The Appointments Clause of the Constitution specifies 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.
In the Hill case, Hill contended the ALJ was an “inferior officer”, while the SEC held he was a “mere employee.” Relying on the Supreme Court’s ruling in Freytag v. Commissioner, May found that “SEC ALJs are inferior officers.” Because the ALJ in question was not appointed by the president, a court of law, or an SEC commissioner, “his appointment is likely unconstitutional in violation of the Appointments Clause.” May preliminarily enjoined the SEC from conducting the administrative proceeding.
Hill’s victory was relatively short-lived. In June 2016, the Eleventh Circuit reversed May’s ruling in Hill and in a similar case, Gray Financial Group v. SEC, finding that the district court lacked subject matter jurisdiction. In doing so, it followed the D.C. Circuit’s reasoning in overturning a district court’s decision in Jarkesy v. SEC. In August 2016, the D.C. Circuit once again sided with the SEC in Lucia v. SEC, supporting the Commission’s use of ALJs. One of the D.C. Circuit’s fundamental arguments in Lucia was that SEC ALJs cannot be considered “inferior officers” under the Appointments Clause because they are not empowered to make final decisions.
What About Bandimere?
The circuit court decisions from the summer of 2016, favorable as they were to the SEC, did not entirely settle the question. Another appeal, this one of an administrative proceeding that had been brought against David Bandimere in 2012, was in the works.
The SEC alleged that Bandimere, a Colorado businessman, had operated as an unlicensed broker between 2006 and 2010, selling millions of dollars worth of stock in what the agency described as Ponzi schemes. A hearing was held quickly, and in October 2013, an ALJ found him liable, imposed a bar from the securities industry, permanently enjoined him from violating the securities laws, and ordered civil penalties and disgorgement. Its findings with respect to Bandimere’s co-respondent, John O. Young, were similar. The initial decision as to Young was reviewed by the SEC and a Finality Order was issued shortly thereafter.
The Commission took no further action on Bandimere’s case for two years. The delay was due to the fact that Bandimere, unlike Young, had appealed the ALJ’s initial decision. In his appeal, Bandimere had raised two constitutional challenges. In the first, he argued he’d been denied equal protection because his case was tried by an administrative judge, and so was “singled out and denied the opportunity for a trial by jury, presided over by an Article III judge, and denied discovery under the Federal Rules of Civil Procedure.” In the second, he argued that Cameron Elliot, the ALJ, was named to his position in a way that violated the Appointments Clause of the Constitution.
In its independent review, released on October 29, 2015, the Commission rejected the equal protection defense on the grounds that Bandimere was far from the only person against whom an administrative action had been brought for offenses similar to those alleged against him. The commissioners did not address the questions of whether he had an inherent right to a trial by jury, or had been denied discovery. They gave greater attention to the Appointments Clause challenge, summoning the arguments that had been used successfully in the various 2015 appellate court cases. Following Landry v. FDIC, the commissioners held that their ALJs were not “principal officers” who must be appointed by the president and confirmed by the senate, nor were they “inferior officers” who must be appointed by the president, heads of departments, or courts of law. They were “’mere employees’ whose appointments are not restricted by the Appointments Clause.” Examining the facts of the case, the commissioners arrived at substantially the same conclusions drawn by the ALJ, and imposed substantially the same sanctions on Bandimere.
Bandimere appealed the decision to the Tenth Circuit. In his petition, he once again raised the Appointments Clause issue, and challenged the SEC’s findings of securities fraud liability. The appellate panel chose to address only the Appointments Clause in its extensive analysis.
The central question, as in the earlier cases, was whether the SEC ALJs were “inferior officers” or “mere employees.” The panel drew up a list of positions held by individuals the Supreme Court had defined as “inferior officers” over more than 150 years, noting that, as Justice Stephen Breyer once said, “the term’s sweep is unusually broad.” Like District Court Judge May, they turned to Freytag for clarity on the issue, saying that because the facts in Freytag and Bandimere are similar, “Freytag controls the result of this case.”
In Freytag, the issue was whether the Tax Court had the authority to appoint special trial judges (STJs) under the Appointments Clause. The Tax Court could assign its STJs to four categories of cases. In three of them, the STJ could both report on and decide the matter; in the fourth, the STJ could be authorized only to hear the case and propose findings, while the actual decision would be made by a regular Tax Court judge. In Freytag, the fourth category applied. The STJ issued a proposed opinion concluding the petitioners were liable, and the Tax Court ratified it. The petitioners argued that the STJs were “inferior officers” under the Appointments Clause, and the clause had been violated because they were not appointed by the president, a court of law, or a department head. The government argued that the STJs were not inferior officers because they lacked the authority to enter a final decision.
The Supreme Court held that although the STJ who heard Freytag was not empowered to render a final decision, his powers and authority went well beyond those of a functionary, or “mere employee,” adding that even if if he “on occasion performs duties that may be performed by an employee not subject to the Appointments Clause,” that does not make him an employee. The court unanimously decided STJs were inferior officers.
In its review of the ALJ’s decision in Bandimere, the SEC conceded that its administrative judges are not appointed by the president, a court of law, or a department head. The appellate panel proceeded to the question of whether they are inferior officers as defined in the Appointments Clause. The SEC’s ALJs must meet stringent requirements to be considered for appointment, and once given the job, they may only be removed for good cause. The Commission can delegate “any of its functions” except rulemaking to them. Their duties, which the appellate panel illustrated with a table, are extensive and complex.
The panel concluded that:
In sum, SEC ALJs closely resemble the STJs described in Freytag. Both occupy offices established by law; both have duties, salaries, and means of appointment specified by statute; and both exercise significant discretion while performing “important functions” that are “more than ministerial tasks”… Further, both perform similar adjudicative functions as set out above. We therefore hold that the SEC ALJs are inferior officers who must be appointed in conformity with the Appointments Clause…
This holding serves the purposes of the Appointments Clause. The current ALJ hiring process whereby the OPM screens applicants, proposes three finalists to the SEC, and then leaves it to somebody at the agency to pick one, is a diffuse process that does not lend itself to the accountability that the Appointments Clause was written to secure. In other words, it is unclear where the appointment buck stops. The current hiring system would suffice under the Constitution if SEC ALJs were employees, but we hold under Freytag that they are inferior officers who must be appointed as the Constitution commands. As the Supreme Court said in Freytag, “The Appointments Clause prevents Congress from dispensing power too freely; it limits the universe of eligible recipients of the power to appoint.”
…The SEC ALJ held his office unconstitutionally when he presided over Mr. Bandimere’s hearing. We grant the petition for review and set aside the SEC’s opinion.
The Bandimere ruling created a split opinion among the circuit courts. That will eventually need to be addressed, either by new appellate hearings, or by an appeal to the Supreme Court.
Todd Feinstein Takes the Alexander Kon Case to District Court
After the Tenth Circuit ruled on Bandimere, the D.C. Circuit reconsidered its decision in Lucia. On February 16, it vacated the original judgment in the case, and agreed to rehear Lucia’s petition en banc on May 24. Needless to say, the SEC did not publicly acknowledge the controversy surrounding the Appointments Clause and its own ALJs, and it continued to bring administrative proceedings against individuals it suspected of wrongdoing.
One of those individuals was Alexander Kon. Kon, a Kansas resident, owns a publication called 007Stockchat LLC, or Stockchat LLC, which is dedicated to the promotion of penny stocks. The SEC alleged that in the spring of 2014, Kon had helped the “former CEO” of an unnamed penny company pump the company’s stock, generating volume and raising price. It appears the company was CannaBusiness Group Inc. (CBGI), whose then-CEO was Michael Cummings. According to the SEC, Kon and Cummings organized the promo together, and agreed on a price of $25,000. Kon sent email blasts from four websites he controlled: 007stockchat.com, awesomestocktips.com, otcfire.com, and pennystockspy.com.
CBGI spiked enormously as the pump began; the operation was helped along by a number of press releases and other kinds of disclosure contributed by Cummings. As nearly always, note holders converted and dumped the resulting stock into the pump, and the price began to drop precipitously. On May 7, the SEC suspended trading in CBGI. When the suspension expired, the stock reopened on the illiquid Grey Market, where it remains.
The SEC brought its action against Kon on November 16, 2016. Its complaint was that Kon had declared payment from a Casey Cummings, though he had actually received a wire transfer directly from Michael Cummings, Casey’s father. The SEC alleges that by failing to disclose that information, Kon violated Section 17(b) of the Securities Act of 1933. On the same day, the agency announced a settled action that had been brought against Casey Cummings, who had been one of the note holders who profited greatly by dumping into Kon’s pump.
Kon decided to fight the SEC’s Order Instituting Proceedings (“OIP”). After the Tenth Circuit ruling on Bandimere was handed down on December 27, he hired attorney Todd Feinstein to file a brief with the SEC arguing that the OIP failed to state a claim, and further that the ALJ assigned to hear the case, Cameron Elliot, was disqualified because his appointment violated the Appointments Clause, as laid out in the appellate court’s analysis of Bandimere. Kon, like Bandimere, is a resident of a Tenth Circuit state. Elliot had been the SEC ALJ who originally presided over Bandimere’s case. In his motion for a ruling on the pleadings—essentially a motion to dismiss the OIP—Kon hoped Elliot would be convinced by the new circuit court ruling.
Enlarging on the sparse allegations contained in the OIP, Kon’s counsel Feinstein, citing SEC v. Gorsek, notes that “[i]n order to violate Section 17(b), a person must (1) publish or otherwise circulate (using a means of interstate commerce), (2) a notice or type of communication (which describes a security), (3) for consideration received (past, currently, or prospectively, directly or indirectly), (4) without full disclosure of the consideration received and the amount.” In this case, the OIP states that the source of Kon’s payment was misidentified as a “non-affiliated third party,” when it should have been identified as the issuer and its CEO, Michael Cummings. Kon contends he fully complied with Section 17(b) when he disclosed the “consideration received and the amount.” As a different action, U.S. v. Wenger, showed, “Section 17(b) contains only two forms of disclosure: (1) that a promoter disclose his status as such, and (2) that a promoter disclose how much he is paid for his promotions.”
In SEC v Recyle Tech, brought in 2012, promoters Jay Fung and Anthony Thompson, who were part of the notorious Awesome Penny Stocks group, made the same argument. The court held that “[b]y its plain language, Section 17(b) does not require affirmative disclosure of the source of consideration received,” and notes further that even had the defendants intentionally misstated the source of consideration to defraud consumers, no relief could be granted under Section 17(b). That alone should warrant dismissal of the OIP, as no other claim is lodged against Kon.
On January 4, 2017, the day after the motion for a ruling on the pleadings was filed, Feinstein filed a short motion asking that Judge Elliot withdraw as disqualified by the Appointments Clause. The judge promptly denied the motion for withdrawal, but agreed to address Kon’s remaining arguments. On January 11, Kon requested an interlocutory review of the Appointments Clause question; two days later, Elliot replied that “[t]o the extent Respondent requests that I certify my ruling for interlocutory review.., I DENY the motion.” On February 21, Kon once again filed a motion for the judge’s withdrawal. Its purpose was to inform Elliot that the D.C. Circuit had vacated its ruling on Lucia and ordered a rehearing en banc. Elliot denied the motion the same day.
The Alex Kon Case Moves to District Court
Clearly Kon was making no headway with Judge Elliot, who continued to insist the Commission believed its ALJs did not act in violation of the Appointments Clause. Kon acquired another lawyer, Marc Wilson of Kansas City, Missouri, who was licensed to practice in Kansas. On February 21, Wilson filed a complaint for declaratory and injunctive relief against the SEC in the United States District Court for the District of Kansas. Its object was to “enjoin the SEC from continuing an unconstitutional proceeding against [Kon] in violation of the U.S. Constitution.”
Wilson explained that Kon “remains embattled in an unconstitutional administrative proceeding,” the final hearing in which is scheduled for April 3. He went on to discuss the earlier appellate cases and the more recent Bandimere and Lucia, noting the current circuit split. He also addressed Kon’s unsuccessful effort to obtain an interlocutory review by the SEC. Arguing that “Plaintiff will suffer permanent and irreparable harm to his business and reputation if the SEC, as it seeks, is permitted to inflict a temporary ‘cease and desist’ or permanent ‘penny stock bar’ on Plaintiff to prevent him from conducting his otherwise permissible business,” Wilson asks that the Kansas court enjoin the SEC from continuing with the administrative proceeding.
On February 23, Kon moved the court for a temporary restraining order and a preliminary injunction to stop the administrative proceeding, and requested oral argument on the motion. In an accompanying memorandum in support, Wilson once again lays out the history of Kon’s and similar cases, noting that “the public interest is served by ensuring that the SEC acts within the limits of the Constitution.”
That is where the Kon action stands now. It remains to be seen whether the Kansas district court will grant the restraining order and injunction requested. Even if they’re denied, Kon would have the option—if he loses his case at the hearing—of appealing the decision first to the SEC Commission, and then, if necessary, to the Tenth Circuit.
Given the number of appeals already in play, and the conflicting rulings handed down by the circuit courts, it seems likely that sooner or later, the Appointments Clause issue will make its way to the Supreme Court. As the New York Times recently pointed out, the SEC could deal with the problem on its own simply by arranging for its ALJs to be appointed by the chairman of the Commission, who is a “head of department.” But that would no doubt result in hundreds, if not thousands, of appeals of administrative actions already adjudicated. The same could of course happen if one day the Supreme Court finds that ALJs working for the SEC and other government agencies were unconstitutionally appointed, but for now, the SEC is probably willing to take its chances.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956 or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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