You Win Some, You Lose Some—The Lynn Tilton Edition

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An SEC administrative law judge easily found for the agency’s Enforcement Division in rejecting the procedural and constitutional challenges to the Commission’s fraud action against fund adviser Lynn Tilton. When it came to tally the final score, however, ALJ Carol Fox Foelak found that the SEC Enforcement Division failed to prove their substantive claims that the so-called “Diva of Distress” bilked investors out of millions of dollars.

Tilton managed several collateralized loan obligation (CLO) funds, which are securitization vehicles in which a special purpose entity, the issuer, raises capital through the issuance of secured notes and uses the proceeds to acquire a portfolio of commercial loans. Tilton used the monies raised from investors to buy or make loans to primarily private, mid-sized distressed companies.

As alleged by the SEC in 2015, Tilton and her firms hid the poor performance of the loan assets in the CLO funds. The SEC claimed that Tilton and her firms breached their fiduciary duties and defrauded clients by failing to value assets using the methodology described to investors in the funds’ offering documents. The SEC charges claimed that nearly all the valuations of the loan assets had been reported to investors as unchanged from the time they were acquired despite many of the companies making partial or no interest payments to the funds for several years. By doing so, Tilton and her partners allegedly collected almost $200 million in fees and other payments to which they were not entitled.

Constitutional Arguments

Tilton aggressively challenged the use of the SEC’s administrative tribunal on procedural and constitutional grounds. She claimed that the ALJ proceedings violated the appointments clause of the constitution and the due process and equal protection clauses, and made other procedural objections. Initially, Judge Foelak stated that the SEC had rejected Tilton’s application for a stay pending court review of the appointments clause question. She also concluded that “the Respondents cite no authority to show that the procedures of the Commission’s administrative proceedings violate the Due Process Clause” and that “Respondents do not claim, let alone establish, that the Commission’s regulatory classification jeopardizes exercise of a fundamental right or categorizes on the basis of an inherently suspect characteristic.” The ALJ cited that the respondents received a Wells notice and the order instituting proceedings, and had at least nine months to prepare for the hearing, and filed and obtained rulings on numerous prehearing motions. The respondents also had a 14-day hearing and the opportunity to call witnesses and cross-examine division witnesses. Tilton’s claims failed to show any lack of fundamental fairness.

Substantive Claims

With regard to the substantive claims, however, ALJ Foelak found the arguments of the division “unpersuasive.” The division failed to prove that the respondents’ accounting methodology was part of an effort to “actively conceal” an increase in missed interest payments. She noted that the investors, sophisticated institutions, could have reviewed the trustee reports and understood the actual cash activity of the distressed loans. Moreover, she stated, uncertainty regarding the collection of accrued interest at a specific point in time does not necessarily mean that a loan must be deemed impaired under GAAP. Even if the accounting was improper, she concluded that GAAP violations, without further evidence of wrongful intent, do not alone indicate fraud.

She concluded that “while there may have been an information asymmetry between Tilton and the noteholders, there was not a power asymmetry ... while Respondents did not maximize the ease of finding it, they also did not conceal—omit to state—material information,” and dismissed the claims.


Initially, unlike a criminal verdict, the Enforcement Division may appeal the initial decision to the full Commission. All parties in an administrative proceeding have this option, but respondents charged by the SEC rarely utilize it for a variety of reasons. The first is that the parties to an SEC action have already expended substantial time and money, and an appeal keeps the legal fee meter and the measure of reputational damage running. In addition, appeals go before the SEC, the body that that made the decision to file suit in the first place, and the respondent must convince the Commission that it, as well as the ALJ, were wrong. Finally, unlike criminal appeals, the SEC has plenary authority to review the initial decision, and can add or increase the ALJ-imposed sanctions.

The SEC as appellant faces different challenges. Despite the rather emphatic rulings by ALJ Foelak on Tilton’s due process claims, administrative proceedings face a perception that they are unfair tribunals that give the SEC an improper “home court” advantage.  One case does not a due process argument make, but it is difficult to look at ALJ Foelak’s opinion and see her work as mere rubber stamp for Commission actions. She held a hearing that covered two weeks, admitted scores of documents into evidence and heard testimony from nine Enforcement Division witnesses, including three expert witnesses. Tilton called nine witnesses, including six expert witnesses, and testified for more than three days. It would be difficult from a public relations standpoint for a Commission seen by many in the defense bar as running a rigged system to overturn a thoughtful, reasoned opinion of more than 50 pages that found fault with the Division’s case.

The U.S. Supreme Court will likely rule on the constitutionality of the ALJ selection process under the appointments clause. The Chief ALJ currently hires other judges as regular SEC employees, rather than the SEC appointing them as inferior officers.

In testimony before the SEC Investor Advisory Committee this summer, Columbia University Law Professor John C. Coffee, Jr., suggested that the SEC already had the solution to the appointments clause problem in its back pocket. To avoid a constitutional challenge to its selection of ALJs, Professor Coffee stated 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 a case involving disgorgement orders and the statute of limitations].

It is difficult to imagine that the high court will strike down the entire administrative proceeding regime, and the SEC has available remedies for the appointments clause problems. It is also difficult to imagine, given that politics is perception, that the SEC will overturn Judge Foelak’s dismissal of the claims. It appears that this is one element of “distress” that the diva has avoided.

For more on SEC administrative law judge decisions, Bloomberg Law subscribers can access our SEC ALJ Enforcement Tracker and accompanying Analytics on the Securities Practice Center.