INSIGHT: Unanswered Questions Following the Supreme Court’s Holding in ‘Lucia v. SEC’

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R. Daniel O’Connor Daniel V. Ward David Nasse Lindsey Sullivan Sara A. Bellin Stefan Schropp

By R. Daniel O’Connor, Daniel V. Ward, David Nasse, Lindsey Sullivan, Sara A. Bellin, and Stefan Schropp

On June 21, the Supreme Court issued a decision in Lucia v. SEC, holding unconstitutional the method previously used by the Securities and Exchange Commission (“SEC” or the “Commission”) to hire its administrative law judges (“ALJs”) and calling into question the validity of proceedings that have historically decided a substantial number of contested SEC enforcement actions. With this decision, the Court held that SEC ALJs are “officers” of the United States subject to the requirement of the Appointments Clause that all such officers be appointed by the President, “Courts of Law,” or “Heads of Departments.” Although the Court squarely answered the narrow Appointments Clause question, in doing so, it declined to address a number of open questions that follow from this significant decision that will undoubtedly result in additional litigation as to the constitutionality of the Commission’s ALJs, as well as to that of other regulators’ ALJ regimes. Indeed, in the wake of the uncertainty created by the Court’s holding in Lucia, the Commission has stayed all pending administrative proceedings for the next thirty days.

The Appointments Clause

The Appointments Clause of the U.S. Constitution authorizes the appointment of two categories of federal “Officers.” The first category, often referred to as a group as “principal officers,” includes Ambassadors, Cabinet Secretaries, Article III judges, and other “Officers of the United States,” who must be appointed by the President and confirmed with the advice and consent of the Senate. The second category consists of “inferior officers,” the appointment of which Congress may vest by law in “the President alone, in the Courts of Law, or in the Heads of Departments.”

The Commission’s ALJs

Congress has authorized the Commission—which is considered by the Supreme Court to be a head of department for Appointments Clause purposes—under the Administrative Procedures Act (“APA”) to appoint ALJs to preside over administrative hearings designed to enforce federal securities laws. Historically, the Commission has, in turn, delegated the power to select those ALJs to the SEC’s career staff, who typically chose from a list of qualified candidates provided by the Office of Personnel Management (“OPM”). Once appointed, the five SEC ALJs who currently oversee the Commission’s administrative caseload “have the authority to do all things necessary and appropriate to discharge his or her duties.” 17 C.F.R. § 201.111.

An ALJ’s “initial decision” may be reviewed by the Commission sua sponte or at the request of a party or other aggrieved person. 17 C.F.R. §§ 201.410, 201.411(c). If further review is not requested, or if the Commission declines such review where discretion allows, the initial decision “shall, for all purposes, including appeal or review thereof, be deemed the action of the Commission.” 15 U.S.C. § 78d-1(c); see also 17 C.F.R. § 201.360(d)(2). When review by the Commission does occur, the Commission may “make any findings or conclusions that in its judgment are proper and on the basis of the record,” and may issue its own opinion. 17 C.F.R. § 201.411(a). The Commission may alternatively remand the case to the ALJ to take additional evidence or may itself take additional evidence. 17 C.F.R. § 201.452. If the aggrieved party does not timely file a petition for review, or if the Commission declines to review the initial decision sua sponte, the Commission will issue an “order of finality” stating that the initial decision has become final and effective. 17 C.F.R. § 201.360(d)(2). A party who is aggrieved by a final order of the Commission may seek judicial review of that order by filing a petition for review directly in a federal court of appeals. See 15 U.S.C. §§ 77i(a), 78y(a)(1), 80a-42(a), 80b-13(a).

Background of Lucia’s Case

Raymond Lucia was an investment adviser charged by the SEC under the anti-fraud provisions of the Investment Advisers Act for misleading investors. As a result, the SEC pursued an enforcement action against him in front of an ALJ. The ALJ found Lucia liable, and imposed a $300,000 fine and a lifetime ban on serving as an investment adviser.

Lucia appealed that judgment to the Commission, arguing that SEC ALJs are the type of “inferior officers” governed by the Appointments Clause. Although the Commission would have qualified as a “Head[] of Department[]” sufficient to constitutionally appoint such an inferior officer, the Commission did not directly appoint the ALJ, but instead delegated its authority to appoint its ALJs to its staff. Upon learning during litigation that the Commission had not directly appointed the ALJs, which previously was not disclosed, Lucia argued that the ALJ who decided his case lacked the requisite constitutional authority and, accordingly, that he was entitled to a new proceeding. The Commission rejected Lucia’s argument by a 3-2 margin and affirmed the judgment of the ALJ.

Lucia then appealed to the D.C. Circuit, arguing that the Supreme Court’s decision in Freytag v. Commissioner was dispositive of the question and entitled him to a new proceeding. In Freytag, the Court held that Tax Court Special Trial Judges (“STJs”) are “inferior officers” because, among other reasons, they have the power to take testimony, conduct trials, rule on the admissibility of evidence, and enforce discovery orders. Leaning on Freytag, Lucia argued that the ALJ in his case had exercised similar discretion over a trial-like procedure and, therefore, must be appointed by the President or the Commission under the Appointments Clause. The D.C. Circuit rejected Lucia’s reliance on Freytag and instead relied on its own prior holding in Landry v. FDIC to find that ALJs are “employees,” rather than “officers,” of the SEC and, therefore, that they are not subject to the Appointments Clause.

Lucia filed a petition for rehearing en banc. While the petition was pending, the Tenth Circuit issued a decision in Bandimere v. SEC , which resolved the same question contrary to the D.C. Circuit by concluding that the SEC’s ALJs are indeed “officers,” rather than “employees.” After the Bandimere decision issued, the D.C. Circuit granted Lucia’s rehearing request but deadlocked with an equally divided court, leaving the panel’s decision in place.

Lucia then filed a petition for certiorari with the Supreme Court based on the split between the D.C. and Tenth Circuits. After Lucia filed his petition, the government undertook two related actions bearing relevance to this case. First, following the confirmation of the Trump administration’s new Solicitor General, the Government abandoned its original position—defending the Commission’s ALJs as employees, rather than officers—and reversed course before the Supreme Court, filing briefs supporting both Lucia’s request for review and his ultimate position on the merits. As a result, when the Court granted Lucia’s petition, it also appointed an amicus curiae to defend the SEC’s then-existing regime. Secondly, the Commission also issued an order purporting to “ratify” the appointment of its ALJs (the “ Ratification Order”). With this Ratification Order, the Commission attempted to “ratif[y] the agency’s prior appointment” of its ALJs in order to “put to rest any claim that administrative proceedings pending before, or presided over by, Commission administrative law judges violate the Appointments Clause.”

The Supreme Court’s Decision

The Supreme Court granted certiorari on the “sole question [of] whether the Commission’s ALJs are ‘Officers of the United States’ or simply employees of the Federal Government,” and by a 6-3 margin, held that SEC ALJs are officers subject to the Appointments Clause.

Unlike the D.C. Circuit, the Supreme Court majority concluded that “ Freytag says everything necessary to decide this case.” Lucia v. SEC, Dkt. No. 17-130, slip op. at 8 (S. Ct. June 21, 2018). Indeed, the majority found there to be no principled distinction between the STJs in Freytag and the ALJs in Lucia, calling them “near-carbon copies.” Id. at 6. As Justice Kagan—who wrote for the majority—pointed out, both the STJs and the ALJs hear testimony, conduct trials, rule on the admissibility of evidence, and enforce compliance with discovery orders. Id. at 8–9. Moreover, the Court observed that the ALJs’ decisions likely exhibit a higher degree of independence than those of the STJs, given that the ALJs’ initial findings of fact and law become final if the Commission declines review.

In relying exclusively on Freytag, the majority’s opinion is perhaps more notable for the questions it left unanswered, rather than resolved. As discussed further below, the majority expressly declined to address the following issues:

  •  The validity of the Commission’s “Ratification Order.”
  •  The Government’s request to examine whether the statutory restriction on the removal of Commission ALJs only “for cause” is constitutional.
  •  The distinguishing characteristics of “officers” subject to the Appointments Clause versus mere government employees (notwithstanding the fact that the majority acknowledged that its prior precedent in this area “is no doubt framed in general terms,” id. at 6).
Having decided that Lucia’s proceedings in front of the SEC were tainted with a constitutional infirmity, the Court was left to craft an appropriate remedial scheme. To do so, Justice Kagan turned to existing Supreme Court jurisprudence, first observing that “one who makes a timely challenge to the constitutional validity of the appointment of an officer who adjudicates his case” is entitled to relief. Id. at 12 (quoting Ryder v. United States, 515 U.S. 177, 182–83 (1995)). Secondly, she noted that “the ‘appropriate’ remedy for an adjudication tainted with an appointments violation is a new ‘hearing before a properly appointed’ official.” Id. (quoting Ryder, 515 U.S. at 183, 188). As a result, the majority determined that Lucia was entitled to a new hearing and—in a conclusion to which Justice Breyer raised strenuous objections—that such a proceeding should occur in front of a different ALJ than the one that had previously decided his case. According to the majority, this latter holding was necessary—notwithstanding the SEC’s Ratification Order—because the ALJ “cannot be expected to consider the matter as though he had not adjudicated it before.” Id.

Justice Breyer’s Opinion

All three minority opinions in this case present interesting insight into potential future areas of litigation and debate, some of which are beyond the scope of this article. However, Justice Breyer’s opinion, in which he concurred in the judgment but took substantial issue with most of its analysis, in particular foreshadows many of the complex challenges left unresolved by the majority’s opinion.

One of Justice Breyer’s core objections to the majority opinion is that the Court should not answer the question of whether ALJs are “officers” under the Appointments Clause without first addressing the question of whether the APA’s statutory “for cause” removal protections for ALJs are also constitutional. Lucia v. SEC, Dkt. 17–130, slip op. at 1 (S. Ct. June 21, 2018) (Breyer, J., concurring in the judgment and dissenting in part). The APA provides that ALJs may only be removed for “good cause” as found by the Merit Systems Protection Board (“MSPB”), and that the members of the MSPB may only be removed by the President for “inefficiency, neglect of duty, or malfeasance in office.” Id. at 5. As a result, Justice Breyer argued that “Congress seems to have provided administrative law judges with two levels of protection from removal without cause”—a statutory scheme expressly precluded by the Court’s decision in Free Enterprise Fund v. PCAOB . Id. Justice Breyer worried that the Court’s decision in Lucia could conflict with Congress’s intent in enacting the APA to provide ALJs with removal protections, should ALJs be considered within the scope of the Free Enterprise Funds holding.

In addition, Justice Breyer—this time with the backing of Justices Ginsburg and Sotomayor—disagreed with the majority’s conclusion that the proper remedy for the constitutional defect required a hearing before a different ALJ. Justice Breyer noted that the reversal in this case was based on a “technical constitutional problem” and should therefore be remanded to the same judge for additional proceedings. Id. at 13. Moreover, he observed that the D.C. Circuit had not considered the proper remedy and objected to the High Court doing so in the first instance. Id.

Implications

Despite the majority’s attempt to frame this relatively short opinion as a natural extension of well-established Court precedent, the full scope of the decision’s impact appears difficult to predict. Perhaps in recognition of this fact, on the same day the opinion was released the SEC issued an order stating that “[i]n light of the Supreme Court’s decision in Lucia v. SEC, we find it prudent to stay any pending administrative proceeding . . . , including any such proceeding currently pending before the Commission” for a period of thirty days. Given the number of questions left unanswered by Lucia, the SEC’s decision to stay any currently pending decisions is not unwarranted. But while this thirty-day break may be a welcome one, the same unanswered questions will confront the SEC Commissioners when—not if—they start hearing cases once again. Indeed, the Commission has already scheduled oral argument in several cases that both fall outside the thirty-day window and squarely present Appointments Clause questions in their briefs.

What is the Fate of the Commission’s Ratification Order?

Beyond the narrow question answered in Lucia, SEC litigants have also already begun to identify the substantial questions left unanswered by the Court. Among those is whether the SEC’s attempt to “ratify” the appointment of its ALJs in November of 2017 successfully cured the constitutional defect. The majority’s determination that ALJs are inferior officers subject to the Appointments Clause gives the Commission, as a head of department, the power to appoint ALJs. However, the Court did not detail what type of appointment scheme would be constitutional, whether the Commission as a collective body must participate in appointments, or whether those appointments must be forward-facing as opposed to retroactive. At least one brief to the Commission has already seized on this issue, arguing that because the SEC’s ALJs were hired by the OPM, not appointed under the Appointments Clause, there was no appointment to ratify and, therefore, the Ratification Order is without meaningful effect. The Court in Lucia declined to decide that question and, as a result, it remains unclear whether the SEC’s current ALJs occupy those posts constitutionally or whether additional remedial action by the Commission is necessary.

One possible solution, of course, is that the SEC could now formally “appoint” the current ALJs going forward, as opposed to the prior “ratification.” Indeed in declining to address the validity of the Ratification Order, the majority posited, in a footnote, on such an alternative approach, stating that “[t]he SEC may decide to conduct Lucia’s rehearing itself. Or it may assign the hearing to an ALJ who has received a constitu­tional appointment independent of the ratification.Lucia v. SEC, Dkt. 17–130, slip op. at 13 n.6 (S. Ct. June 21, 2018) (majority opinion) (emphasis added). Whether the majority’s footnote hints at some skepticism as to the validity of the Ratification Order remains an open question. Nevertheless, if such a new appointment would be seen as a tacit admission of an additional constitutional or statutory defect and what, if any, remedy to offer those litigants who appeared before the “ratified” ALJs are considerations that only further complicate the questions facing the Commission. Whatever the decision from the SEC, litigants both before ALJs and on appeal to the Commission are likely to increasingly make this argument in the days and months to come.

How Many Cases Will Be Impacted?

Secondly, the Court also declined to decide what, if any, remedy is available to litigants who did not make a “timely challenge” to the constitutionality of their proceedings. For some litigants—including those who failed to raise the issue and have now exhausted the time for appeal—the Court’s opinion likely offers little in the way of relief. For others—namely those who properly raised a challenge prior to the SEC’s “ratification” and who still have a pending appeal—the decision may offer some relief, depending on whether and how the SEC is able to cure the constitutional issue. Between those extremes, however, exist a number of litigants—including, by the SEC’s estimate, those in the 106 cases for which an ALJ had already issued an initial decision at the time of the Commission’s Ratification Order and many other cases filed since—for whom the import of today’s decision is much less clear.

New ALJs in Every Case?

Moreover, even assuming that the Commission has the power to ratify the prior appointment of its ALJs, the Ratification Order instructed the original ALJ for any cases in which an initial decision had been entered to revisit their previous findings in light of the new developments. Given the Supreme Court’s decision that the appropriate remedy involves a new hearing in front of a new ALJ, it is unclear what, if any, curative effect the Ratification Order may have had. Thus, in addition to burdening its ALJs with a secondary review of previously decided cases, the Commission may now be in a position where it preemptively remands all previously-decided cases to a new ALJ, who must then decide the case in the first instance. While the burdensome nature of such a decision is surely a problem in the short term, the consequences of not doing so—and living in a state of uncertainty as new cases make their way through the appellate process—necessarily invite consequences as well.

Removal Issue Clearly on the Horizon.

Additionally, Justice Breyer urged in dissent that the Court’s ruling may call into question the constitutionality of the removal protections afforded to ALJs under the APA. The Supreme Court previously held in Free Enterprise Fund that a dual-protection statutory removal scheme, such as the one that protects SEC ALJs from removal without cause, was unconstitutional because it effectively divested the President of his powers under the Executive Vestment Clause. As Justice Breyer indicates in his Lucia opinion, however, Free Enterprise Fund may apply narrowly so as not to implicate ALJs. Indeed, the Free Enterprise Fund court explicitly distinguished ALJs from the PCAOB, noting that ALJs “perform adjudicative rather than enforcement or policymaking functions,” 56 U.S. 477, 507 n.10 (2010), and do not have the same “significant and unusual” protections from Presidential oversight, id. at 506.

The Solicitor General’s certiorari-stage brief to the Supreme Court urged the Court to consider the removal issue raised by Justice Breyer as an additional question presented by this case. The Court declined that invitation, noting that “[n]o court has addressed that question, and we ordinarily await ‘thorough lower court opinions to guide our analysis of the merits.’” Lucia v. SEC, Dkt. 17–130, slip op. at 4 n.1 (S. Ct. June 21, 2018) (majority opinion) (quoting Zivotofsky v. Clinton, 566 U.S. 189, 201 (2012)). Should Free Enterprise Fund apply to ALJs, then—as Justice Breyer warns—SEC ALJs could become figures bent to the will of the President rather than the independent decision makers contemplated by the APA.

Impact Beyond the SEC.

It is not just the SEC that is taking note of the Court’s holding, given that it is not clear whether, or to what extent, this decision will affect other administrative agencies that use a comparable process to hire ALJs who are then vested with adjudicatory powers. Indeed, in April 2018 the Commodity Futures Trading Commission (“CFTC”)—with explicit reference to Lucia—issued a “ Ratification and Reconsideration Order,” in which it purported to ratify the appointment of its sole “Judgment Officer” and ordered her to undertake a secondary review of all then-pending proceedings. The ALJs of the Federal Deposit Insurance Corporation (“FDIC”) have also faced constitutional challenge like the one raised in Lucia with the Fifth Circuit Court of Appeals recently holding that a respondent had made a strong showing that FDIC ALJs were “officers” not properly appointed under the Appointments Clause. Burgess v. FDIC , No. 17-60579 (5th Cir. 2017). Similar issues have also been raised with respect to the sole ALJ at the Consumer Financial Protection Bureau (“CFPB”), as well as questions about whether the Director of the CFPB qualifies as a “Head[] of Department” capable of making an appointment of inferior officer. Both the parties and the Court in Lucia expressed conflicting views as to the effect of any decision on other administrative agencies and the opinion provides no insight as to the expected scope of the holding. As a result, lower courts could be left to litigate the impact of Lucia on Social Security Administration or Immigration judges, among others, who were hired by agency staff instead of appointed by department heads.

What Is the Practical Effect on SEC Adjudications?

Lastly, the extent to which the above-mentioned implications will be realized has yet to be determined. The Commission is not confined to the use of administrative proceedings for all adjudications and may also bring enforcement actions in federal court. Moreover, the Commission itself has the power to preside over all administrative cases. 17 C.F.R. § 201.111. As a result, even if the Ratification Order is not considered a constitutional mechanism for appointment, the SEC may still avoid administrative upheaval by shifting its reliance on ALJs to federal judges or to the Commission.

Conclusion

In short, while the Lucia majority grounds its holding in clearly-established Court precedent, the ultimate outcome is far from predictable. The opinion undoubtedly provides those with cases currently pending before SEC ALJs another avenue of attack, but, in doing so, produces more questions than answers. The Court does not provide any insight into the opinion’s impact on cases pending before ALJs that were not originally appointed by the Commission but have since been ratified, the validity of the SEC’s retroactive approach to appointment, the design of a constitutional appointment scheme, the scope of the decision’s application to other agencies, or the proper remedy that would address any or all of these questions. Moreover, classifying ALJs as inferior officers raises the possibility that the APA’s statutory removal scheme, which ensures ALJs’ independence, is unconstitutional. As a result, although the solution to the narrow question in Lucia—namely, having the Commission appoint its ALJs—appears straightforward, the opinion could have wide-reaching implications on the architecture and constitutionality of administrative adjudications.

R. Daniel O’Connor , a former SEC trial attorney, co-leads the Securities & Futures Enforcement practice from the Boston office of Ropes & Gray. Dan works with public companies and investment advisers, as well as senior individuals at these firms, involved in civil and criminal government enforcement matters before the SEC, DOJ, and other state and foreign regulators.

Daniel V. Ward is a litigation & enforcement partner based in the Boston office of Ropes & Gray. He has a wide range of experience in complex commercial disputes and securities litigation, including trials and appeals, SEC investigations and international arbitration. His clients include investment advisers (including private equity sponsors, hedge funds and REITs), public companies, and individual officers and directors.

David Nasse is litigation & enforcement counsel in the Washington, D.C. office of Ropes & Gray. David represents investment advisers, financial institutions, public companies, and senior executives in civil and criminal enforcement matters before the DOJ, SEC, CFTC, self-regulatory organizations, and other state and foreign regulators.

Lindsey Sullivan is litigation & enforcement counsel in the Chicago office of Ropes & Gray. She focuses her practice on defending clients in investigations and enforcement actions before the Securities & Exchange Commission.

Sara A. Bellin is a litigation associate in the Boston office of Ropes & Gray.

Stefan Schropp is a litigation associate in the Washington, D.C. office of Ropes & Gray.

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