How SEC Enforcers Got Back to Basics

By Russell G. Ryan*

Since leaving the Securities and Exchange Commission in 2004, I haven’t hesitated to question SEC enforcement policy on the op-ed pages of The Wall Street Journal and elsewhere. So it’s only fair, nearly two years into the tenure of current SEC leadership, to give credit where it’s due.

ENCOURAGING SIGNS

As it happens, plenty of credit is due in at least six areas of SEC enforcement policy:

Better accountability. About ten years ago, the SEC departed from historical practice by delegating to senior enforcement staff the commissioners’ legal responsibility for launching formal investigations and unleashing the power to issue subpoenas. Some of us publicly expressed concerns at the time about this dilution of political accountability, given the severe reputational harm and financial expense that can result from investigations, even if no wrongdoing is ever uncovered. 

Happily, in February 2017 the SEC's then-acting chairman partially reversed this delegation to ensure that formal investigations with subpoena power now can be launched only after approval by the politically-appointed SEC commissioners or the agency’s top enforcement official. Thus, current policy at least partially restores the commissioners’ historical accountability for initiating formal investigations. But a return to personal sign-off by the appointed commissioners in all cases would be even better.

Less home-court advantage. About five years ago, the SEC again departed from historical norms by steering more enforcement cases away from federal courts with jury trials and into the agency’s own non-jury administrative tribunals, which created a perception that SEC prosecutors were seeking unfair home-court advantage. Many of us raised due-process concerns about this forum-shifting gambit, which ultimately backfired when the Supreme Court ruled last summer in Lucia v. SEC that the agency’s administrative law judges (ALJs) were appointed unconstitutionally – a decision that effectively required the commission to re-litigate or settle dozens of cases then pending on its administrative docket. 

Yet even before Lucia was decided, current SEC leadership appeared to foresee the impending havoc and, to its credit, preemptively reappointed its ALJs and quietly began reverting to the historical norm of litigating most contested enforcement cases in federal courts – especially those seeking harsh sanctions based on disputed allegations of fraud.

Still, numerous concerns linger with in-house agency adjudication of law-enforcement cases (and not just at the SEC). Having apparently solved the problem with how its ALJs were appointed, the SEC now faces challenges to the layers of removal protection those ALJs enjoy. And although the agency amended its procedural rules in 2016 to reduce some of the disadvantages faced by the accused in administrative proceedings, the SEC can never really solve the most basic concern of all: the untenable concentration of legislative, executive, and judicial power that exists when the commission simultaneously (i) writes the rules, (ii) authorizes and supervises its prosecutors when they enforce those rules, and (iii) ultimately decides guilt or innocence (and the severity of any punishment) when its prosecutors accuse someone of breaking the rules.

Fewer forced admissions. In yet another departure from historical practice, the SEC in 2013 began requiring some accused wrongdoers to publicly admit their sins if they wanted to settle with the agency and avoid costly litigation. The concerns some of us expressed at the time went unheeded, and the SEC went on to secure admissions of wrongdoing in dozens of settlements over the ensuing years. Northern Illinois University law professor David Rosenfeld recently published a comprehensive analysis of the affected cases through early 2017, from which he concluded that the policy requiring admissions was applied “inconsistently and haphazardly” with “a complete lack of transparency in the process.” 

Recent SEC settlements suggest the agency has reconsidered its 2013 policy shift and largely stopped demanding admissions, effectively reverting to the historical norm of allowing parties to settle while neither admitting nor denying wrongdoing. This return to normalcy has the added virtue of bringing SEC enforcement practice back into alignment with section 202.5(e) of the agency’s informal procedural rules, which has explicitly allowed no-admit settlements since 1972. Although the SEC continued to demand a diminishing trickle of forced admissions during 2018, the agency’s experiment with that practice appears to have largely run its course, and none too soon.

Here too, however, the SEC faces lingering challenges. Among other things, a recent lawsuit by the Cato Institute is challenging the SEC’s ability even to prohibit settling parties from publicly denying the agency’s allegations of wrongdoing.

De-emphasis on statistics. In recent months senior SEC leaders have publicly underplayed the importance of statistical metrics in evaluating the success of the agency’s enforcement program. This refreshing perspective reverses decades of SEC and media obsession over the number of cases filed each year and the aggregate monetary sanctions imposed. That obsession rested on (and reinforced) the toxic premise that effective enforcement is synonymous with ever-increasing case filings and eye-popping penalties. It also invited speculation that agency staff were incentivized to pursue quick and easy cases over more difficult ones, even when the latter had broader importance to investors and markets, and to demand arbitrarily large penalties in settlements with deep-pocketed companies desperate to avoid litigation. Even if that speculation was unfounded, an end to the obsession with numbers was long overdue.

Better PR hygiene. My Wall Street Journal op-ed in late 2014 pointed out how SEC press releases announcing enforcement charges had become unfairly prejudicial and otherwise inconsistent with legal precedent governing due process, particularly in administrative cases where the commissioners would eventually play the role of final adjudicators. Among other things, these pre-hearing press releases were blurring the crucial distinction between proven fact and mere allegation. They were also routinely including unofficial quotations from the SEC prosecution team without affording the same courtesy to the accused, and they rarely mentioned that the allegations had yet to be proved at a hearing. To its credit, the SEC has since improved the balance and fairness of its enforcement-related press releases, although the unfair practice of allowing its prosecution team to insert gratuitous, one-sided quotations into official press releases unfortunately persists.

Return to core mission. Over the past two years the SEC has noticeably pulled back from its brief foray into “broken windows” policing, whereby even unintentional, technical violations were penalized regardless of whether ordinary investors suffered any harm. The agency appears to have returned to its core enforcement mission, prioritizing cases where fraud or other intentional misconduct caused widespread harm to retail investors – such as deceptive securities offerings, dishonest or conflicted investment advice, and misleading accounting or disclosures by publicly-traded companies. And in a subtle but telling gesture, the SEC website recently erased the agency’s debatable claim – originally coined in the 1990s – that it is “first and foremost” a law-enforcement agency.

A WISH LIST FOR FURTHER PROGRESS

The SEC deserves great credit for accomplishing all of the foregoing in relatively short time, with little fanfare, and despite a shrinking enforcement staff. But here are three more areas where the SEC could make truly game-changing strides to further improve fairness and legal clarity:

• Strictly limit the use of in-house administrative proceedings to (i) settled cases, (ii) contested cases where the respondent consents to the administrative forum, (iii) routine "follow-on" cases against SEC-regulated people and entities after they've already been found liable in an underlying criminal or civil proceeding; (iv) cases that, by statute, can be pursued only in the administrative forum (such as failure-to-supervise cases); and (v) some other tiny and well-defined category of cases where no form of punitive sanctions are sought.
• Face reality on disgorgement. No matter how many times the SEC and lower courts repeat their familiar mantra, the kind of disgorgement the SEC seeks in the vast majority of its cases is not an "equitable" remedy, and it's only a matter of time before the Supreme Court officially says so, as presaged by footnote 3 of its unanimous 2017 decision in Kokesh v. SEC. In cases where disgorgement is not an equitable remedy, the SEC simply has no lawful power to seek it and courts have no lawful power to order it. This reality is understandably frustrating. But the best options for changing it include either convincing Congress to amend the law or seeking disgorgement only in cases where it is at least arguably an equitable remedy rather than a legal or punitive one – that is, when illicit profits from misconduct have been segregated and frozen (either voluntarily or by court order) and the SEC intends to disburse those specific funds to proven victims. There's little point in racking up additional hard-fought disgorgement orders that will become subject to challenge under Federal Rule of Civil Procedure 60(b) as soon as the Supreme Court inevitably rules that they were unlawfully entered.
• Embrace a heightened burden of proof in cases that seek punitive sanctions based on allegations of fraud. The incendiary nature of fraud charges, along with the quasi-criminal sanctions routinely sought and imposed, should require a governmental authority to prove those charges with at least clear and convincing evidence, if not proof beyond a reasonable doubt. The current preponderance-of-evidence standard is an anachronistic holdover from a by-gone era in which the SEC had no power to seek punitive sanctions when it sued in court.

LOOKING AHEAD

Those last three suggestions are almost certainly a pipe dream. Still, the enforcement program under current SEC leadership is off to a very promising start. Here’s hoping the agency will continue along this road back to basics through 2019 and into the next decade.

Please leave a comment if you agree or disagree.

*Russell G. Ryan, a partner with the law firm King & Spalding LLP, previously served as assistant director of enforcement at the SEC and deputy director of enforcement at the Financial Industry Regulatory Authority (FINRA).