Financial advisers squaring off against the SEC in front of administrative law judges suddenly have a new tool for their defense, thanks to an unexpected court ruling on Tuesday.
By deciding that the hiring process for the Securities and Exchange Commission's in-house judges is unconstitutional, the 10th U.S. Circuit Court of Appeals in Denver has put a fresh light on the debate over the power and reach of the SEC's administrative court system.
“For pending cases, there is now a well-thought-out opinion from a Court of Appeals that says, as designed, the current administrative law judge system is not constitutional,” said Andrew Morris, a partner at the law firm of Morvillo.
“That means if you're somebody subject to this process you should be putting you heads together with your lawyers and looking at its effect,” he added. “You should be looking at ways to raise the argument that you're involved in a proceeding that a court has ruled unconstitutional.”
The 10th Circuit Court ruling is still a long way from revising the SEC's current practice of hiring administrative law judges through a traditional civil servant process.
But the fact that the court ruled that administrative judges should be appointed, instead of hired, could breathe new life into several high-profile challenges to the SEC's administrative court system.
The 10th Circuit Court's 2-1 decision effectively nullified the 2013 ruling against Colorado businessman David Bandimere, who was found guilty of violating securities laws for acting as an unregistered broker from 2006 to 2010. Mr. Bandimere's appeal was won by proving that the hiring process by which the SEC's administration law judges are placed is unconstitutional. The appeals court ruling dissolves the $1.2 million fine the ALJ levied against Mr. Bandimere in 2013.
Dawn Bennett, an adviser who has been fined by the SEC more than $4 million and barred from the securities industry, made her distaste for the administrative court clear by refusing to appear at her hearing.
Challenging the authority and constitutionality of the SEC's administrative court system, Ms. Bennett has tried unsuccessfully to have her case moved to district court. Her case is currently awaiting a decision by the SEC, after which her lawyers say the expected ruling will be appealed at the circuit court level.
The new ruling is significant in that it conflicts with a D.C. Circuit Court of Appeals that sided with the status quo at the SEC.
Legal experts say the split decision between the two courts could drive the case to the U.S. Supreme Court, unless the SEC decides to short-circuit the issue by changing its policies for placing its five judges.
SEC spokeswoman Judith Burns declined to comment on the ruling beyond saying, “We are reviewing the opinion.”
Mark Cahn, a partner at the law firm of WilmerHale and former general counsel at the SEC, said the “conflict among the circuits” could have a chilling effect on future SEC enforcement actions.
“The [10th Circuit] decision only adds to the uncertainty of whether administrative law judges are constitutionally appointed and whether an administrative decision will be subject to constitutional challenge,” he added. “Until these issues get resolved, this uncertainty will need to be a factor that the commission considers in deciding whether to proceed administratively in contested enforcement actions.”
For the 2016 fiscal year, the SEC's administrative law judges issued 170 initial decisions, held 11 hearings, and ordered approximately $12.4 million in disgorgement and approximately $14.5 million in civil penalties.
The SEC has always hired its judges, but criticism of the administrative court system gained momentum following the 2010 passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
“The SEC hardly ever loses in front of their own judges, and Dodd-Frank gave them authority to bring more issues and that's why the investment community thinks the dice are loaded,” said Todd Cipperman, managing principal of Cipperman Compliance Services.
Amy Lynch, president of FrontLine Compliance, also believes the latest ruling bodes well for current defendants and that the issue “falls squarely within the realm of the Supreme Court to make the final decision.”
“However, whether or not they will take the case at all becomes a question of priorities and those priorities may change once the court's current vacancy is filled by [Donald] Trump,” she added. “The new president will most likely appoint a strong Republican conservative who may very well be against government regulation and therefore against the concept of [administrative law judges] as a whole.”
Whether the SEC changes its policy for placing administrative law judges voluntarily or by court order, it is not expected to change the outcome of past rulings.
“The courts are very conscious of trying to avoid ripple effects,” said Mr. Morris of Morvillo. “The open question will be the effect on existing cases.”