The SEC's Ill-Fated Piggyback Gambit

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Every now and then, the Securities and Exchange Commission takes a litigation position so plainly unfair that you have to wonder what the agency was thinking.

A recent example is the agency’s unprecedented attempt to invoke a legal device called “nonmutual offensive collateral estoppel” against an investment adviser named Stuart Frost and his eponymous advisory firm Frost Management Company.?Despite the esoteric moniker, nonmutual offensive collateral estoppel is relatively straightforward:?It’s when a plaintiff tries to score a quick win, without having to prove its case, because the defendant previously lost a similar lawsuit filed by some other plaintiff.

This legal maneuver stands in obvious tension with due process and the right to defend oneself, but it does play a legitimate role under limited circumstances.?For example, courts often give the SEC an automatic win on civil fraud charges if the same defendant has already been criminally convicted of substantially identical fraud charges after a jury trial. ?

That makes sense, sort of.?After all, an accused criminal typically has ample incentive to mount a vigorous defense against charges that could lead to incarceration or other severe punishment.?And if a unanimous jury of peers has found that defense unconvincing beyond reasonable doubt, it’s fair to assume the defense would fare no better under the SEC’s less demanding burden to prove merely that guilt is more likely than innocence.

But there’s still a serious due process concern.?Many criminal defendants are convicted after – and sometime because – they exercised their constitutional right not to testify in their own defense, yet they might choose to testify in a subsequent civil case.?Giving the SEC an automatic win in such circumstances deprives the defendant of that opportunity, which might significantly shift the weight of the evidence if the SEC were required to prove its case at trial.

Whatever the merits of allowing the SEC to piggyback on prior criminal convictions, however, the agency’s unprecedented gambit in the Frost case was a bridge too far.?Frost and his advisory firm had previously lost a private arbitration dispute with several of their clients.?And although there was substantial overlap between the arbitration claims and the SEC’s claims, the SEC was not a party to the arbitration and that proceeding was not decided by a court or jury.?

Still, the SEC sought an effortless win against Frost and his firm based on the arbitration result.?Citing the Supreme Court’s 1979 decision in Parklane Hosiery Co. v. Shore – which allowed a private plaintiff to piggyback on a prior civil judgment obtained by the SEC against the same defendant – the agency argued that the arbitration decision against Frost and his firm precluded them from defending themselves against the SEC’s charges.?Thankfully, a federal judge would have none of it and is requiring the SEC to prove its case at trial this year.

In her decision in mid-October, U.S. District Judge Josephine Staton exposed – with considerable understatement – the obvious deprivation of due process the SEC was attempting.?Among other considerations, the stakes are much higher when the SEC seeks to publicly brand someone a lawbreaker and to impose harsh monetary and other career-ending punishment than they are in a private arbitration with only monetary damages in play, so the incentive to mount a make-or-break defense against the SEC is also far greater.?

In addition, securities arbitration proceedings are relatively informal – and notoriously light on due process protections.?They are designed as a relatively quick and inexpensive way to resolve private disputes without any particular concern for the broader public interest.?

Arbitrators routinely consider hearsay and other unreliable evidence that would not be allowed in a courtroom, they sometimes decide cases as much on emotion and gut instinct than on the facts and technical law, and they often don’t provide meaningful explanations for their decisions.?There’s no jury available, and courts are generally forbidden from second-guessing arbitrator decisions after the fact.

It’s surprising – and a bit disturbing – that the SEC would even try to get away with this kind of shortcut to victory.?At least the agency implicitly acknowledged that no court had ever handed it an automatic win based on a prior arbitration outcome.?But the reason for that lack of precedent should have been obvious:?The whole idea is completely nuts.

And while we’re on the subject, this isn’t the only way the SEC takes shortcuts to victory based on the questionable reliability of prior litigation outcomes.?The SEC has long insisted in its “follow-on” disciplinary proceedings – those in which it administratively determines whether to bar or suspend someone from the securities industry based on, among other possible predicates, a court judgment the SEC previously obtained against them – that the facts the agency alleged in the underlying case are deemed conclusively true and uncontestable, even if that prior case was settled (as most are) with no adjudication of the facts, no findings of wrongdoing by the court, and no admission of liability by the settling party.?In essence, expedience and administrative convenience trump fairness and due process.

Happily, the Frost case proves that the SEC’s ability to score easy piggyback wins is not limitless.?When the SEC wants to impose harsh punitive sanctions and deprive people of their livelihoods and reputations, the least we should expect is that the agency actually prove its own case.

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

The opinions expressed by this author are his alone and do not necessarily reflect the views of his law firm, his colleagues, or his clients. His articles and postings are solely for general information purposes and are not intended to be, and should not be, read or interpreted as legal advice.