Tag: Supreme Court

Supreme Court Limits SEC Internal Tribunals

“When the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment entitles the defendant to a jury trial.”

SEC v. Jarkesy

The case presented three issues:

(1) Whether statutory provisions that empower the Securities and Exchange Commission to initiate and adjudicate administrative enforcement proceedings seeking civil penalties violate the Seventh Amendment.
(2) Whether statutory provisions that authorize the SEC to choose to enforce the securities laws through an agency adjudication instead of filing a district court action violate the nondelegation doctrine.
(3) Whether Congress violated Article II by granting for-cause removal protection to administrative law judges in agencies whose heads enjoy for-cause removal protection.

The Supreme Court ruled on the first item and didn’t address the other two. Fights for another day.

Dodd-Frank granted the Securities and Exchange Commission broader rights to use its internal administrative law tribunals for non-registered parties. [Section 929P(a)]. Of course with the addition of private fund managers by Dodd-Frank, the world of non-registered parties got smaller.

Mr. Jarkesy and his Patriot28 fund were investigated by the SEC for inflating the fund values and lying about its service providers prior to Dodd-Frank. It decided to charge them using the in-house tribunal by using its new authority under Dodd-Frank. Mr. Jarksey lost the decision in 2014 and has been fighting ever since.

The Supreme Court decision looks at the Public Rights Exception to Article III jurisdiction. This exception allows some matters to go through administrative law proceedings and don’t require Article III proceedings. The Supreme Court essentially determines that civil penalties are designed to punish and deter and not compensate. Therefore, a case seeking civil penalties can’t go through the in-house tribunal.

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The SEC Administrative Law Judges Are Heading to the Supreme Court

The use of administrative law judges by the Securities and Exchange Commission has been strained since the jurisdiction was expanded under Dodd-Frank. There have been a series of cases challenging the ALJs under the the Appointments Clause of the Constitution. The problem was that the judges were appointed by an internal panel instead of by the President or the SEC Commissioners.

An advertising case that led to an adviser being barred is now headed to the U.S. Supreme Court. In the Lucia case, the lower court used a three prong test to determine if an ALJ is an “Officer” under the Appointments Clause:

  1. significance of the matters resolved by the government official
  2. discretion the official exercises in reaching the decision
  3. the finality of the decision

On Jan. 12th, the Supreme Court granted an appeal to hear Lucia v. SEC. This was likely based on two factors.

One was a split in the courts on whether the SEC’s administrative law judges were properly appointed. The 10th Circuit Court of Appeals came to the opposite conclusion in Bandimere v. SEC. That court used a different three part analysis to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;
(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and
(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

The second was that the Department of Justice decided that the ALJ appointment process was flawed. That position dropped in the Solicitor General’s Brief on Writ of Certiorari for Lucia the argument is now to hear the case and overturn the Lucia ruling.

“[T]he government is now of the view that such ALJs are officers because they exercise ‘significant authority pursuant to the laws of the United States.’ Buckley v. Valeo, 424 U.S. 1, 126 (1976)”

In response, the SEC ratified all the ALJ appointments. This should fix the problem and erase the constitutional problem.

In the reply brief, Lucia argued that the government’s change of its position and its revised procedures did nothing for him.

“Although the government now agrees that SEC ALJs are Officers, it has afforded petitioners no redress for having subjected them to trial before an unconstitutionally constituted tribunal… On the contrary, petitioners remain subject to draconian sanctions—including a lifetime associational bar—resulting from the tainted proceedings below”

It looks like the SEC has fixed the problem with its ALJs going forward. The problem will be what to do with all of the cases that have already been decided. It seems likely that the SEC is going to agree that the ALJs were a problem. The big question is how to fix that problem for the cases that have already been adjudicated. I would guess that there are a lot of cases that going be expunged, people no longer barred and cash fines repaid.

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Supreme Court Limits One of the SEC’s Remedies

The Securities and Exchange Commission has essentially been claiming that its remedy of disgorgement is not subject to a statute of limitations. To the SEC, disgorgement is not punitive but remedial in that it lessens the effects of a violation by restoring the status quo.

Charles Kokesh decided to fight back against this position. In the SEC’s case against him, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”. If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

Yesterday, the Supreme Court agreed with Mr. Kokesh and set a limit on the SEC’s powers.

Disgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462. Accordingly, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.

In addition to limiting the period susceptible to disgorgement, the Supreme Court indicated that a facial attack on the disgorgement remedy in footnote 3:

Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to §2462’s limitations period.

The Supreme Court noted that the SEC specifically has the powers of injunction and civil penalties. Perhaps the disgorgement could be tested. In the decision, the Supreme Court noted that the “SEC disgorgement sometimes exceeds the profits gained as a result of the violation” and, ” as demonstrated by this case, SEC disgorgement sometimes is ordered without consideration of a defendant’s expenses that reduced the amount of illegal profit.”

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The SEC Reaching Back Far In The Past With Its Powers of Disgorgement

We have become used to the Securities and Exchange Commission extracting disgorgement of ill-gotten gains from those violating the securities laws. However, the enabling laws do not explicitly grant the SEC the right to disgorgement. We seem to accept that power, but how far back can the SEC go to grab cash from defendants?

In the SEC’s case against Charles Kokesh, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. Some of that ill-gotten cash was overcharging to pay expenses of the investment advisory firm, but some went into his pocket and that of his stable of polo ponies. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”.

If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

The briefs and arguments are a delight for legal scholars. The parties are battling over legal history and dictionary definitions to determine what Congress meant in 1839 when it passed that five year limit and used the word “forfeiture.”

The arguments are compounded by the creation of the SEC’s power of disgorgement, not by Congressional action, but by case law. The SEC only legitimized disgorgement in 1970 in the case of  SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970).

The Kokesh case was argued in front of the Supreme Court last month, so we should be looking ahead to decision shortly that may have a profound impact on SEC enforcement actions.

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Compliance and Supreme Court Nomination

One of the most important roles of the President is appointing judges to the bench, with an opening on the Supreme Court being the most important. We are set for another battle over an opening because the process lacks a set of policies and procedures.

SCOTUSbuilding_1st_Street_SE

The vast majority of Supreme Court cases are uninteresting except to the set of practitioners in that legal area. A few cases each term have broader social issues and attract the headlines. It’s those cases on abortion and marriage and gun rights that attract the most attention.

Justice Scalia took a very dogmatic approach to his view of the US Constitution. He was an originalist and textualist who believed in a static view of the Constitution. Conservatives loved this approach since it mostly aligned with their beliefs. Scalia would have been the first say that his view was not political, but a pure legal view.

He would also likely view with disdain some of the posturing coming out of Washington on how his open spot should be filled.

The Constitution grants the President the power to appoint Justices, “by and with advice and consent of the Senate.”

Scalia himself had an easy route to appointment as a Justice because the Senate opposition had focused its efforts on Rehnquist’s appointment as Chief Justice. It’s hard to fight a battle on two fronts.

The current appointment will also be about politics, and not legal theory. I’m sure the nominee will have a brilliant legal mind. He or she will likely have a short judicial record with few, if any, decisions on controversial issues. I would also guess that the nominee will not be a white male.

Leaving the Supreme Court seat open means that there are an even number of justices. Therefore, a tie is possible and impossible to reach a decision. Any governance practitioner will tell you the perils of an even numbered board.

Compliance practitioners should note that there is an insider trading case before the court. In the Salman case, the Supreme Court will try to decide if personal benefit to the insider is necessary as required in the Second Circuit’s Newman case or whether it is sufficient that there was a close family relationship as decided in this case. It would be a shame to not have a decision because of a vacancy on the bench.

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Supreme Court of the United States Building, Washington, DC, as seen from the west side of 1st St NE.
by 350z33
CC BY SA

Supreme Court Rules on the Privacy of Text Messages

Sort of.

The Supreme Court issued its ruling in Ontario v. Quon regarding a police chief reviewing the content of a police officer’s text messages with consent or a warrant. Many commenters hoped that the Court would issue a broad statement on an employee’s privacy rights in this age of cloud computing and web 2.0.

The Court chose to rule on very narrow grounds and not address the electronic privacy issue:

“A broad holding concerning employees’ privacy expectations vis-à-vis employer-provided technological equipment might have implications for future cases that cannot be predicted. It is preferable to dispose of this case on narrower grounds.”

The Justices were hesitant to jump into the battle about electronic privacy:

“The Court must proceed with care when considering the whole concept of privacy expectations in communications made on electronic equipment owned by a government employer. The judiciary risks error by elaborating too fully on the Fourth Amendment implications of emerging technology before its role in society has become clear.

…

Prudence counsels caution before the facts in the instant case are used to establish far-reaching premises that define the existence, and extent, of privacy expectations enjoyed by employees when using employer-provided communication devices. Rapid changes in the dynamics of communication and information transmission are evident not just in the technology itself but in what society accepts as proper behavior.”

Instead, the Justices looked narrowly as the special situation of the government as an employer.  Since its the government, the Fourth Amendment’s protection against warrantless searches comes into play. (This is not applicable for a private employer.)  The standard  is that

“when conducted for a “non-investigatory, work-related purpos[e]”or for the “investigatio[n] of work-related misconduct,” a government employer’s warrantless search is reasonable if it is “‘justified at its inception’” and if “‘the measures adopted are reasonably related to the objectives of thesearch and not excessively intrusive in light of’” the circumstances giving rise to the search.”

Even if a government employee could assume some level of privacy in their messages, it would not have been reasonable for them to conclude that his messages were in all circumstances immune from scrutiny by the government employer.

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Quon Roundup on Employee Computer Privacy

Lots of discussion about the Quon case focused on the lack of technology expertise by the Justices on the Supreme Court. Actually, most people labeled them as Luddites. DC Dicta even claims that Chief Justice Roberts writes his opinions in long hand with pen and paper.

This issue that I am hoping to see addressed is how a stated policy on the use of a company’s hardware and network can be enforced in light of an employee’s expectations of privacy.

I doubt that issue will be addressed directly. The Quon case involves a government employee so the discussion of the issue will likely focus on the Fourth Amendment protection. These protections are largely irrelevant for private employees.

Even if the Justices avoid the Fourth Amendment issues, they may decide the case under the Stored Communications Act. That’s a rather boring and technical law. It’s also largely irrelevant to the use of a company’s hardware and network. Although it may provide some insight for the use of cloud computing and web 2.0 site.

The United States Government, through the arguments of Neal K. Katyal, Deputy Solicitor General, seemed to ask the Court to adopt a bright-line rule that a company can trump the reasonableness of any employee’s expectation of privacy by issuing a policy that employees have no privacy in communications when using the company-provided hardware or network.

The Justices seemed fairly skeptical of that kind of bright-line rule in their questions of Mr. Katyal.

The problem is that tightly crafting laws to specifically address the use of particular communication technologies will fail. In the current environment, the technological advances in communications is moving much faster than the cogs of  bureaucracy in crafting regulations. The Supreme Court (well, at least Justice Alito) recognized that the expectations of privacy with new communication are in flux.

“There isn’t a well-established understanding about what is private and what isn’t private. It’s a little different from putting garbage out in front of your house, which has happened for a long time.”

The ruling in the case is expected sometime June at the end of the Supreme Court’s term. It’s certainly something for compliance professionals to keep an eye on.

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Image of P2000 Pager.JPG is by Kevster

Supreme Court Rules on When Mutual Fund Fees are too High

The Supreme Court issued its opinion in Jones v. Harris Associates, addressing the standard for when mutual fund fees are too high.

Background

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The Jones v. Harris case starts with the claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to its Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

Judge Easterbrook in the Seventh Circuit rejected the Gartenberg standard and crafted a new one.  The court adopted a standard that an allegation that an adviser charged excessive fees for advisory services does not state a claim for breach of fiduciary duty under § 36(b), unless the adviser also misled the fund’s board of directors in obtaining their approval of the compensation.

Decision

The Supreme Court concludes that

“Gartenberg was correct in its basic formulation of what §36(b) requires: to face liability under §36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship tothe services rendered and could not have been the product of arm’s length bargaining.”

They also make it clear that the burden of proof is on the party claiming the breach, not the fiduciary.

The Supreme Court found fault is looking almost entirely at the element of disclosure. The result is that the Supreme Court overturned the Seventh Circuit and remanded it back for further proceedings.

What does the standard mean?

The Investment Company Act does not necessarily ensure fee parity between mutual funds and institutional clients. Courts need to look at the similarities and differences in the the services being provided to different clients.

Courts should not rely too heavily on comparing fees charged by other advisers. Fees may not be the product of arm’s length negotiations.

A court should give greater deference to fund fees when a board’s process for negotiating and reviewing compensation is robust. “[I]f the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.” If a fund adviser fails to disclose material information to the board, the court should use greater scrutiny.

“[A]n adviser’s compliance or non-compliance with its disclosure obligations is a factor that must be considered in calibrating the degree of deference that is due a board’s decision to approve an adviser’s fees.”

The result is that courts should defer to the “defers to the informed conclusions of disinterested boards” and hold “plaintiffs to their heavy burden of proof.”

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Tuesday Morning Quarterback of Free Enterprise v. PCAOB

pcaob logo

On Monday, the Supreme Court listened to the oral arguments in Free Enterprise Fund v. Public Company Accounting Oversight Board (08-861). For me in the compliance world, the case is about the viability of PCAOB under Sarbanes-Oxley. For the constitutional scholars it is an important separation of powers case.

Responding to concerns about accounting that led to the collapses of Enron and WorldCom, Sarbanes-Oxley established PCAOB as an independent body to oversee the firms that do accounting for public companies. The law gives the Securities and Exchange Commission power to name the members of the Public Company Accounting Oversight Board.

The trouble is that the President has no power to remove the Commissioners of the SEC, other than the Chair. The President can only appoint them. Similarly, the SEC selects the board members of PCAOB, but cannot remove them. The Free Enterprise group says that violates a clause of the Constitution giving the president the power to appoint government officials except for certain instances involving inferior officers.

If the Supreme Court agrees that PCAOB isn’t constitutional, it could force a revisit of Sarbanes-Oxley, or at least the portion of it that creates PCAOB. In a broader view for constitutional scholarship, the case could also call into question other independent agencies and how they appoint members of those agencies.

David Zaring in The Conglomerate thinks that the Supreme Court is unlikely to get in the way of an important government agencey. After all eliminating an agency is a sever sanction.

Orin Kerr in The Volokh Conspiracy> got the impression that the arguments did not go well for the challengers to the constitutionality of the Public Company Accounting Oversight Board.

Fawn John Johnson and Jess Bravin in The Wall Street Journal look to Justice Kennedy as the key to which way the Supreme Court will decide. The liberal justices are less likely to find fault with the independent agencies. For conservative legal scholars, the case is less about the accounting board itself than about the “unitary executive” theory, which holds that because the president is accountable to the electorate, he must be able to remove federal officials at will.

The transcript and reports seem to focus on how much control the SEC has over PCAOB. Hans Bader points out that the SEC had previously expressed its frustration about how little control it had over PCAOB, seemingly contrary to the arguments made in front of the Supreme Court.

David Zaring in The Conglomerate points out that the number of law review articles referring to “PCAOB”: 1021.  Number referring to “PCOAB”: 29. So much for the higher scholarship and editing of law review articles over blogs.

UPDATE:

Broc Romanek, of The Corporate Counsel.net provides a great first-hand account of the hearing and his experience at the Supreme Court the day of the hearing: My SCOTUS Experience: The Full Monty.

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Will the Supreme Court Affect Mutual Fund Fees?

supreme court

On Monday, the Supreme Court heard the arguments on a case involving mutual fund fees. The case is trying to reconcile the standard for when mutual fund fees are too high.

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The Jones v. Harris case starts with the claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to its Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

The parties argued their positions Monday in front of the Supreme Court. I was not there, but I thought I could collect some coverage and Tuesday Morning Quaterbacking of the arguments.

According to the coverage, neither party supported Chief Judge Easterbrook’s ruling in the Seventh Circuit. He had found that the marketplace may be trusted to curb excessive fees and that mutual fund investors unhappy with the fees they are charged could withdraw their money and invest it elsewhere.

The mutual fund side argued for the Gartenberg standard: Fees must be “within the range of what would have been negotiated at arm’s length in the light of all of the surrounding circumstances.”

The plaintiff side argued:

“It surely cannot be the case that where you are dealing with a fiduciary duty — which is a higher standard recognized in the law — that you can charge twice as much as what you are obtaining at arm’s length for services that you are providing.”

William Birdthistle thinks:

“If, as some of today’s questions seem to indicate, the eventual decision from the Court in Jones v. Harris will read like Gartenberg with just one additional factor included in an already long and nebulous evaluation, we might have to wait for the next wave of litigation in trial courts to see whether the new Jones standard makes any practical difference on fees. If, on the other hand, the justices highlight and strongly emphasize the institutional/individual fee comparison in an opinion that reads like Posner’s dissent or Ameriprise v. Gallus, the pressure upon the industry to lower fees could be more acute and immediate.”

Anna Christensen thinks:

There did not seem to be five votes for adopting the Seventh Circuit’s market-based approach. The Court may reject that standard and decide little else, perhaps adopting the basic Gartenberg test with some degree of explication, and sending the case back to the court of appeals for application of the test. On the other hand, the Court may decide that as the argument in this case demonstrates, the terms of Gartenberg test do not provide significant guidance on how to identify an unfairly large fee, and use the facts of this case to provide an object lesson to lower courts.

It sounds like the Supreme Court is unlikely to come out with a ruling that dramatically affects the industry. Inevitably, it will require additional work for compliance.

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