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December 29, 2014

colosseumThe SEC’s decision to bring more enforcement cases as administrative proceedings has raised the hackles of many industry participants. Some have likened the SEC administrative tribunal to England’s Star Chamber, used in the 16th century to suppress political and religious dissent. Others have called it a “rocket docket” that places respondents at a disadvantage. Not only is there the perceived bias that captive administrative judges will favor SEC enforcement attorneys, there’s the logistical difficulties posed by discovery restrictions and tighter discovery deadlines.

A number of administrative respondents have challenged the SEC’s authority to bring cases in its “home court.” Most notable was Rajat Gupta’s 2011 federal lawsuit challenging the constitutionality of the administrative insider trading case the SEC brought against him. Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York denied the SEC’s motion to dismiss the suit. In finding that Gupta stated an equal protection claim, the Court noted that the SEC’s administrative complaint against Gupta was largely similar, both in the facts alleged and the remedies sought, to its allegations against 28 other defendants in related insider trading cases filed in a federal district court.

Because the SEC and Gupta settled that aspect of their dispute by dismissing their respective suits, Judge Rakoff never had the opportunity to make a substantive ruling on whether a SEC administrative proceeding can violate a respondent’s right to equal protection. See In the Matter of Rajat K. Gupta, SEC Release No. 33-9249. But Judge Rakoff’s Southern District brethren, Judge Lewis A. Kaplan, has gotten a little closer. Wing F. Chau and his firm, Harding Advisory LLC, sought to enjoin an administrative proceeding in which the Enforcement Division alleged that Chau, who managed a collateralized debt obligation (“CDO”) through Harding, made material misrepresentations in the sale of the CDO.

Chau and Harding argued that the decision to sue them administratively and not in a court established under Article III of the U.S. Constitution violated their right to due process and equal protection. After Judge Kaplan denied a motion for a temporary restraining order, the administrative action proceeded and the parties are currently awaiting the administrative law judge’s decision.

It is in this context that Judge Kaplan addressed plaintiffs’ motion for a preliminary injunction and the SEC’s motion to dismiss the lawsuit for lack of subject matter jurisdiction.  Writing that its “jurisdiction is not an escape hatch for litigants to delay or derail an administrative action when statutory channels of review are entirely adequate,” the Court denied the preliminary injunction motion and dismissed the case.

The Court acknowledged the questions raised over the SEC’s use of administrative rather than Article III courts. But, it notes, those are policy matters for the legislative and executive branches to consider. Emphasizing the fact-specific nature of these cases, the Court concluded it lacks subject matter jurisdiction here because if plaintiffs lose before the Commission, they will have a full opportunity to present their arguments before a U.S. Court of Appeals.

And that is precisely the position in which two former senior executives at State Street Global Advisors find themselves.

In 2010, the Enforcement Division instituted administrative proceedings against John P. Flannery and James D. Hopkins for allegedly misleading investors in State Street’s Limited Duration Bond Fund about the extent of subprime mortgage-backed securities the fund held. See the SEC Press Release. But Chief SEC Administrative Law Judge Brenda Murphy didn’t agree, finding that neither Flannery nor Hopkins was responsible for, or had ultimate authority over, the allegedly false and materially misleading documents at issue. Moreover, those documents did not contain materially false or misleading statements or material omissions. In the Matter of John P. Flannery, Initial Decision Release No. 438.

The Enforcement Division appealed and over three years later, the Commission voted 3-2 to reverse the ALJ. SEC Chair Mary Jo White, joined by Commissioner Luis A. Aguilar and Kara M. Stein, found that Hopkins knowingly and Flannery negligently made material misstatements. The Commission suspended each for one year and ordered Hopkins to pay a $65,000 penalty and Flannery to pay a $6,500 penalty. In the Matter of John P. Flannery, SEC Release No. 33-9689.

According to Reuters, Flannery and Hopkins will appeal the Commission’s decision to the U.S. Appellate Courts. A case that was initiated in September 2010 over conduct that occurred in 2007 is slated to continue well into 2015 and most likely into 2016.

So after five years of active litigation Flannery and Hopkins will get their day in an Article III court. But whether that judicial proceeding will clarify the constitutionality of SEC administrative proceedings remains to be seen.

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