A Quick Cup of “Coffee”—The Financial Choice Act and the Future of SEC Enforcement

Capitol Building

John C. Coffee, Jr., a Columbia University law professor, described the impact of the Financial CHOICE Act as passed by the House on the future of SEC enforcement actions as a “mixed bag” in remarks last week before the SEC Investor Advisory Committee. According to Professor Coffee, the bill contains a provision that could cripple the existing enforcement program and another that he referred to as the “nuclear option,” while much of the rest of the bill amounted to sound and fury signifying little, if nothing at all.

Section 823—The “Crippling” Provision

Professor Coffee noted that for fiscal 2016, the SEC brought almost 80 percent of its enforcement actions in its in-house administrative forum. While many of these involved routine matters, such as delinquent filing cases, a significant percentage of these proceedings involved matters such as insider trading that previously would have been heard in federal district court.

The provision of the bill that could hamstring the SEC’s administrative enforcement program is found in Section 823. That section allows respondents charged in administrative proceedings that could result in cease and desist orders and penalties to remove their cases to federal court. Professor Coffee suggests that the “vast majority” of persons charged would do so.

The shift of emphasis to the courts presents several challenges for the resource-strapped agency. Court cases can take years to work their way through the system, while administrative proceedings are often resolved in a matter of months. Defendants in civil trials are entitled to extensive discovery, and the SEC must prepare its case to present to a jury, rather than an administrative law judge (ALJ) who is well-versed in federal securities law. Section 823 also imposes a heightened standard of proof in administrative proceedings, requiring the SEC to present “clear and convincing evidence” of the violation. The increased costs and demands of federal court litigation would likely cause the SEC to bring fewer cases, and to settle claims on less favorable terms than would have been available in the administrative forum.

Professor Coffee pointed out one odd interplay between statutory sections that present an unintended consequence of encouraging some litigants to forego the removal option remain before an ALJ rather than a district judge. Under Section 825, officer and director bars would only be available in court proceedings. While litigants in general would likely choose the district court route, an individual facing the severe sanction of a prohibition from serving as an officer or director of a public company may well choose the administrative forum to foreclose that possibility.

Section 211—The “Nuclear Option”

This section seems relatively non-controversial, as it increases the amount of civil penalties that can be recovered in both ALJ and district court actions. Section 211 provides a new penalty cap for cases involving “fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement.” There are three different penalty limits, with the cap set at the largest of the three. The first two measures are unremarkable, with a top end fine of $300,000 for an individual or $1,450,000 for any other entity, or three times the gross amount of the violator's pecuniary gains. The nuclear aspect comes with the third alternative, where penalties can be set at “the amount of losses incurred by victims as a result” of the misconduct. Professor Coffee cites the example of an insider trader who realizes $150,000 in illicit profits, but sellers in the market on the same dates incurred combined losses of $5 million. This figure, and not the three times gain totaling $450,000, would be the penalty cap. According to the professor, "this is a huge change, and one wonders if the draftsmen of the House bill knew what they were doing."

The Sound and Fury

In Professor Coffee’s view, many Financial CHOICE Act provisions serve to make the SEC’s job more difficult without commensurate measurable benefits. For example, Section 824 requires the SEC’s Division of Economic and Risk Analysis (DERA) to make two separate findings before seeking a civil penalty against an issuer. DERA must first determine whether the alleged violation would result in a direct economic benefit to the issuer, and whether the penalty would harm the company's shareholders.

He asserted that the second finding was essentially automatic, because penalties always harm shareholders. He rejected the Commission’s argument that such penalties can benefit shareholders by alerting them to corporate governance problems out of hand, calling it “Orwellian doubletalk that few courts will take seriously.” He cited two examples of egregious misconduct which resulted in no clear benefit to the issuer. The first involved a company that issued misleading financial statements that resulted in a precipitous stock price drop when it revealed its true condition. Investors suffered substantial losses but the company realized no gains from the inflated stock price because it issued no shares during the period. Another example involved a company bribing a foreign official in violation of the Foreign Corrupt Practices Act. Although the issuer knowingly violated the FCPA, in Professor Coffee’s example, the bribe failed and another bidder received the contract, resulting in no financial gain for the issuer.

He noted that the provision as drafted does not require DERA to reach any particular finding on these questions for the SEC to be able to seek a penalty. The division could find that there was no benefit to the issuer and significant harm to shareholders, but the SEC could still pursue a penalty. He suggested that the rather awkward draftsmanship could serve to embarrass the SEC or deter the enforcement staff from bringing penalty cases in the face of adverse findings.

In another example of a remedy that may be in search of a problem, Professor Coffee cites Section 821. This section grants the recipient of a written notice that the SEC is considering bringing an enforcement action against them (a "Wells Notice") “the right to make an in-person presentation before the Commission staff concerning such recommendation and to be represented by counsel at such presentation.” This rather skeletal provision contains no requirement that any particular SEC personnel attend such a presentation, or when or where it would be scheduled. According to Professor Coffee, this provision transforms a technique to open negotiations into a setting “for the aggrieved defendant to confront his accusers and berate them.“ He suggests that the staffers required to attend these rather pointless exercises "should hold out for a higher salary."

Challenges to Administrative Enforcement

Professor Coffee noted the multiple challenges that the SEC currently faces on the enforcement front. He initially mentioned the Supreme Court decision on the appropriate limitations period for disgorgement actions in Kokesh v. SEC, which, as discussed here, may serve to remove much of the SEC’s leverage in reaching settlements with respondents. There are also the well-publicized challenges to the authority of the agency’s ALJs under the Appointments Clause of the Constitution. There is currently a split between the circuits, with the Commission surviving a motion for an en banc review of a decision in its favor by the D.C. Circuit by an equally-divided court, on the legitimacy of these positions. These in-house judges are hired by the chief ALJ rather than appointed by the Commission. If ALJs are “inferior officers” of the government, rather than typical Civil Service employees of the agency, they must be appointed by the president, a court or a department head. According to Professor Coffee, precedent suggests that the SEC is “destined to lose” on the issue. He stressed that an adverse appointments clause finding does not, however, cast constitutional doubt on the legitimacy of administrative prosecutions in general, and that there is a relatively simple solution to the Commission’s appointments problem.

To avoid a constitutional challenge to its selection of ALJs, Professor Coffee suggested that the SEC could reappoint all current ALJs, and then after the reappointment, the judges could reconfirm all prior rulings in pending cases without any new hearings. For future hires, the SEC could also maintain the Chief ALJ’s role in the process by having the chief judge make recommendations for Commission consideration. Professor Coffee doubted that the SEC would take his advice, stating that:

Culturally, such a decision would be difficult for the SEC. The SEC is a somewhat elderly agency, with increasingly hardened arteries, and it cannot change easily. Like the Vatican, a similar institution in many respects, the SEC believes itself generally infallible and expects the Supreme Court to protect it, which assumption proved very wrong in the recent Kokesh decision on disgorgement.

The professor suggested that securities lawyers should pay attention to the high court’s grant of certiorari in Oil States Energy Services LLC v. Greene’s Energy Group, LLC. On its face, the case does not suggest an immediate connection with the securities laws, as it deals with a complex administrative procedure in intellectual property cases, and arose in a case concerning inventions for use in hydrocarbon fracking. Professor Coffee suggested, however, that the Court might use this seemingly narrow issue to call the constitutional legitimacy of many administrative proceedings into question. “If the Court is concerned that administrative proceedings eclipse the citizen’s right to a jury trial,” he observed, “the SEC is again in serious trouble.”