The Securities and Exchange Commission (SEC) faces a constitutional crisis: the Tenth Circuit recently held that SEC administrative law judges (ALJs) are unconstitutionally appointed.[1] And the D.C. Circuit will likely soon follow suit. So far, the SEC is fighting hard to protect thousands of past and pending SEC adjudications; however, the battle may well have been lost. Here’s the story of how the SEC’s greatest constitutional challenge unfolded.
Six years ago, Congress enacted the Dodd-Frank Act,[2] for the first time giving the SEC the power to seek monetary penalties in an in-house adjudication. The SEC already had the power to seek such penalties in federal court. With the Dodd-Frank Act, the SEC’s enforcement division could choose which forum to use: an adjudication before an SEC ALJ or a civil action before an Article III judge.[3]
With its new forum, the SEC soon realized it had a significant home-court advantage. A Wall Street Journal study reported that from October 2010 to March 2015, the SEC’s enforcement division prevailed in 86% of the proceedings it brought in-house, while it prevailed in 70% of the cases it brought in federal court.[4] The Wall Street Journal further noted that in fiscal year 2014, the SEC’s enforcement division prevailed in 100% of its administrative proceedings, while it prevailed in only 61% of the cases it brought in federal court.[5][6] In response, respondents to SEC enforcement actions challenged the SEC’s new choice, arguing inter alia that the SEC ALJs were unconstitutionally appointed.[7] Respondents argued that because the SEC ALJs are inferior officers of the United States, they must be appointed by the President, a court of law, or the head of a department. Instead, they are appointed by the head SEC ALJ.
In December 2016, the United States Court of Appeals for the Tenth Circuit agreed with respondents in Bandimere v. SEC.[8] Bandimere involved an appeal from an SEC administrative enforcement proceeding presided over by an SEC ALJ. The respondent had argued in the underlying enforcement proceeding that the SEC ALJ was an inferior officer and was unconstitutionally appointed; however, the SEC rejected that argument.[9] On appeal, the SEC conceded that if the SEC ALJ were an inferior officer, he was unconstitutionally appointed.[10] However, the SEC argued that its SEC ALJs are merely employees, not inferior officers.[11] The Tenth Circuit disagreed and held that because the SEC ALJ was an inferior officer who was not appointed as the Constitution required, he “held his office unconstitutionally when he presided over Mr. Bandimere’s hearing.”[12]
To reach its holding, the majority relied on the Supreme Court’s 1991 opinion in Freytag v. Commissioner.[13] In Freytag, a unanimous Court had held that the Tax Court’s special trial judges (STJs) were inferior officers and not employees.[14] The Court identified three factors for courts to consider when determining whether an employee is an inferior officer: First, whether the position was “established by law;” second, whether “the duties, salary, and means of appointment for that office are specified by statute”; and third, and most importantly, whether the employee exercises significant duties and discretion.[15] Applying these factors, the Bandimere majority concluded that the SEC ALJs were inferior officers because the position was established by the Administrative Procedures Act; statutes set forth the SEC ALJs’ duties, salaries, and hiring process; and the “SEC ALJs exercise significant discretion in performing ‘important functions’ commensurate with the STJs’ functions described in Freytag.”[16]
The majority then explicitly rejected the SEC’s argument that the Court in Freytag had relied on the STJs’ ability to make final decisions to hold that the STJs were inferior officers.[17] In doing so, the majority criticized the D.C. Circuit’s 2000 decision in Landry v. FDIC,[18] upon which the SEC relied.[19] In Landry, the D.C. Circuit had held that FDIC ALJs were not inferior officers because they did not have final decision-making authority.[20] The Bandimere majority correctly noted that the D.C. Circuit in Landry misinterpreted Freytag.[21]
The Tenth Circuit’s decision in Bandimere caused a circuit split. Earlier in 2016 in Raymond J. Lucia Co., Inc. v. SEC, a three judge panel of the D.C. Circuit had followed its reasoning in Landry, rather than the Supreme Court’s reasoning in Freytag.[22] In Lucia, the D.C. Circuit held that the SEC ALJs were merely employees because they do not have final decision making authority.[23]
The circuit split may not last long. The D.C. Circuit recently granted the petitioner’s petition for rehearing en banc in Lucia.[24] The parties have been directed to brief two issues: (1) whether the SEC administrative law judge who handled the hearing is an inferior officer rather than an employee, and (2) whether the court should overrule Landry.[25] It thus appears likely that the D.C. Circuit will reverse Lucia and, like the Tenth Circuit, hold that the SEC ALJs are inferior officers who are unconstitutionally appointed. Assuming that the court does so, the SEC should reappoint its ALJs, this time constitutionally. But a question remains: how can the SEC fix the “thousands of [invalid] administrative actions” the unconstitutional ALJs have issued?[26]
I answer these and other questions are in my recent article,[27] explaining why the SEC ALJs’ appointment violates the United States Constitution and why there is no easy fix. Further, I note that it is not just the SEC ALJs’s appointment process that is constitutionally infirm. In addition, the SEC ALJs, indeed all ALJs, are subject to multiple for-cause removal protections. In 2010 in Free Enterprise Fund v. Public Company Accounting Oversight Board, the Supreme Court held that dual for-cause removal provisions violate separation of powers.[28] Possibly, the Supreme Court will refuse to extend its holding in Free Enterprise to ALJs given the potential impact on the administrative state. However, if the Court meant what it said and if the case is to have any relevance beyond the agency involved, then the multiple for-cause removal provisions affecting the SEC ALJs specifically and all ALJs generally will need to be fixed. The constitutional challenges raised in these cases are far from inconsequential. Thousands of ALJs may be subject to unconstitutional appointment and removal provisions. Thus, the shadow of Free Enterprise looms large.
Footnotes
[1] — F.3d —, No. 15-9586, 2016 WL 7439007 (10th Cir. Dec. 27, 2016).
[2] See generally Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376, 1376–2223 (2010) (codified in scattered sections of U.S.C. titles 7, 12, 15, 22, and 42).
[3] Dodd-Frank Wall Street Reform and Consumer Protection Act § 1055(a)(1).
[4] Jean Eaglesham, Fairness of SEC Judges Is in Spotlight, Wall St. J. (Nov. 22, 2015, 9:25 PM).
[5] See Nate Raymond, U.S. Judge Criticizes SEC Use of In-House Court for Fraud Cases, Reuters (Nov. 5, 2014, 1:37 PM).
[6] At least one academic believes that the SEC statistics are being used inaccurately and that the SEC is no more likely to prevail before an ALJ than in court. See generally Urska Velikonja, Reporting Agency Performance: Behind the SEC’s Enforcement Statistics, 101 Cornell L. Rev. 901 (2016).
[7] See, e.g., Duka v. SEC, 124 F. Supp. 3d 287, 289 (S.D.N.Y. 2015).
[8] — F.3d —, No. 15-9586, 2016 WL 7439007 (10th Cir. Dec. 27, 2016).
[9] Id. at *2.
[10] Id. at *3 (citing SEC Release No. 9972, 2015 WL 6575665, at *19).
[11] See id. at *10.
[12] Id. at *15.
[13] 501 U.S. 868 (1991).
[14] Id., at 881-82.
[15] Id.
[16] Bandimere, 2016 WL 7439007 at *8-9.
[17] Id. at *10.
[18] Landry v. FDIC, 204 F.3d 1225 (2000).
[19] Bandimere, 2016 WL 7439007 at *10.
[20] Landry, 204 F.3d at 1125-44.
[21] Bandimere, 2016 WL 7439007 at *10.
[22] 832 F.3d 277, 283 (D.C. Cir. 2016) (reh’g granted Feb. 16, 2017).
[23] Id. at 283–89.
[24] Id.
[25] Order docketed, No. 15-1345 (D.C. Cir. Feb. 16, 2017).
[26] Id., at *25 (McKay, C.J., dissenting).
[27] Linda D. Jellum & Moses M. Tincher, The Shadow of Free Enterprise: The Unconstitutionality of the Securities & Exchange Commission’s Administrative Law Judges, 70 SMU L. Rev. __ (forthcoming 2017).
[28] 561 U.S. 477, 483–84 (2010).
Linda D. Jellum is the Ellison C. Palmer Professor of Tax. She teaches Tax Courses, Administrative Law, and Statutory Interpretation. In addition to teaching, Professor Jellum is a prolific scholar and has written extensively in the areas of Tax Law, Administrative Law, and Statutory Interpretation.
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