SEC in-house justice system stacks the deck

The Securities and Exchange Commission must revisit aspects of its use of in-house judges to try civil enforcement cases. The agency must be fair in legal proceedings against the financial community and, just as importantly, it must appear to be fair, or Congress could step in and restrict its powers.

The perception that the agency’s use of in-house judges is unfair has grown in recent months. A Wall Street Journal study found that when enforcement cases were tried before in-house judges, the SEC won more than 90% of the time (not far short of Communist Chinese prosecutors’ record 99.9% success rate), versus 69% in cases tried in federal district court.

The disparity between the record in federal district court and the record before in-house judges is prima facie evidence of an unfair system.

In addition, a federal appeals court judge ruled in June that the SEC’s use of an in-house judge to preside over an insider-trading case was “likely unconstitutional” because of the way the judge was hired. The Constitution required “officers,” such as judges, to be appointed by the president, the courts or the people running the agency rather than a bureaucratic process, the appeals court judge said. The SEC hired the judge through its office of in-house judges without getting the appointment approved by the five commissioners.

And when one of the in-house judges rules against the agency, the SEC can appeal, as it did most recently in a case involving the Robare Group, a Houston-based financial advice firm.

The SEC claims the use of administrative law judges is fair, but unlike in federal court cases, defendants have no broad discovery right. Before trial, they are not allowed to obtain copies of documents the SEC has and cannot compel witnesses to provide pretrial testimony. Also, there is no jury. The initial decision is made by the judge hired by the SEC and any appeal is heard by the five SEC commissioners.

ODD AGAINST

The odds are against the defendant at that first appeal stage because the appeal is heard by the same five people who determined the case should go forward in the first place, i.e., that there was a good chance the defendant was guilty. In effect, the commissioners act as both grand jurors and appeals judges.

Theoretically, the commissioners review the record of the case with no deference to the administrative law judge’s ruling, a claim that must be viewed skeptically given that the Wall Street Journal study found the commissioners decided in their own agency’s favor 95% of the time between January 2010 and March 2015.

If the defendant loses at that point — highly likely — he or she can then go to the federal appeals court. However, even there the deck appears to be stacked against the defendant because the court is required to defer to the SEC’s expertise.

DISPARITY IN OUTCOMES

The SEC attributes the difference in outcomes partly to case mix. For instance, most of its complicated insider-trading cases have been heard in federal court, not by its in-house judges. But the disparity in outcomes is too great to be explained in this way.

It also argues that the administrative proceedings save the agency and the defendant time and money.

But there are too many questionable aspects to this process for it to be perceived as fair, and most defendants would want a fair process rather than a speedy one. The agency should not sacrifice fairness for lower costs.

The SEC must find a way to make the process fairer. It can, for instance, cut the five commissioners out of the initial decision to pursue enforcement action, leaving it to top officials of the enforcement division. That way, the commissioners do not serve as members of the grand jury and then as appeals court judges.

The agency must provide fairer pretrial discovery rules. SEC investigators must hand over their evidence to defendants before trial so the defense team has time to examine it and prepare responses.

The SEC can make such changes voluntarily, or it can resist and continue to insist there is no problem, and risk the chance that Congress will step in and clip its wings in ways it will not like.

Meanwhile, financial advisers should let their congressional representatives, and the SEC, know how they feel about the current process.