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Some Constitutional Clarity for SEC Administrative Law Courts but Uncertainty Remains

In a 26-page decision, the U.S. District Court for the District of Columbia rejected an effort by a hedge fund manager to derail an ongoing SEC in-house “follow-on” enforcement proceeding.[1] The administrative action sought to suspend or bar the Rev. Emmanuel Lemelson from the securities industry following a federal court jury verdict finding him liable for violations under the anti-fraud provisions of the federal securities laws in connection with statements he made about a biotech company he was shorting. The court’s comprehensive opinion affirmed the legitimacy of the SEC’s administrative proceeding but left unanswered the merits of the larger constitutional question concerning whether tenure protection enjoyed by SEC administrative law judges (ALJs) violates Article II of the Constitution. As discussed in a prior article, the Lemelson suit also came with a twist when the SEC unexpectedly dropped its Article II defense of ALJs during the briefing of its motion to dismiss.

Lemelson’s preliminary injunction complaint challenged the SEC’s follow-on proceeding on an array of grounds:

  • Claim One: Due process violations under the Fifth Amendment.
  • Claim Two: Usurpation of judicial power vested in the courts under Article III of the Constitution.
  • Claim Three: Denial of a trial by jury under the Seventh Amendment.
  • Claim Four: Violations of Article II of the Constitution based on multi-layer removal protections enjoyed by ALJs.
  • Claim Five: Res judicata based on the SEC’s failure to seek an associational bar against Lemelson in a separate Massachusetts federal district court action, which entered a final judgment permanently enjoining him from violating the anti-fraud provisions of the federal securities laws.[2]

The SEC then filed a motion to dismiss Lemelson’s complaint under Federal Rules of Civil Procedure 12(b)(1) (lack of subject matter jurisdiction) and 12(b)(6) (failure to state a claim).

In deciding that it lacked subject matter jurisdiction to hear Lemelson’s third and fifth claims, the court relied on Section 203(f) of the Investment Advisers Act of 1940 (Advisers Act). The court noted that Section 203(f) explicitly authorizes the SEC to bring follow-on administrative proceedings in certain circumstances to oversee regulated participants. Section 203(f) empowers the SEC to “suspend or bar a participant” after “notice and opportunity for hearing” if that participant was enjoined “in connection with the purchase or sale of any security” in a separate federal district court action. Section 203(f) also provides that any order that is issued at the conclusion of the follow-on proceeding is reviewable in the U.S. courts of appeals.

After a detailed analysis of precedent, the court held that it lacked subject matter jurisdiction to hear Lemelson’s jury trial and res judicata claims because Congress had provided an "alternative scheme of review." The court observed that these claims are of “the type Congress intended to be reviewed within the statutory structure” of the Advisers Act and that the “Advisers Act created a statutory scheme for follow-on proceedings that relies on decision-making by the SEC.” The court also held that the Advisers Act provides Lemelson with an opportunity to seek meaningful review of any final SEC order — including Lemelson’s claim that he is entitled to a jury trial — by challenging that order in a federal appeals court.

As to claims one, two, and four, the court held that Lemelson failed to state a claim. With respect to Lemelson’s due process claim, he argued that his rights were violated because “adjudicators” were allowed to “decide their own cases.” The court quickly dispatched with this argument, however, by finding that “the D.C. Circuit has already rejected this [due process] argument.” The court relied on an opinion that turned aside similar due process challenges based on Section 15(b)(4) of the Securities Exchange Act of 1934 (an analogous “alternative review scheme” to Section 203(f)), which permitted follow-on proceedings against broker-dealers based on the entry of a federal district court injunction. The court then went on to distinguish multiple cases that Lemelson argued contravened the precedent the court had relied on and concluded that he did not state a claim.

The second claim asserted that follow-on proceedings usurp judicial power and therefore violate Article III. Relying again on Supreme Court precedent, the court noted that Congress has “significant latitude to assign adjudication of public rights to entities other than Article III courts.” Lemelson vigorously argued that follow-on proceedings, however, do not involve public rights. Nonetheless, the court was unpersuaded and held that “Lemelson challenges a follow-on proceeding that deals with a public right, so the Court dismisses this claim.”

Finally, the court addressed the fourth claim related to Article II. The SEC (represented by the DOJ) originally argued that ALJ removal protections were constitutional and alternatively argued that even if they were not constitutional that Lemelson had not plausibly alleged that “ALJ tenure protections caused him any harm.” The SEC later abandoned the argument that removal protections were constitutional but maintained that, in any event, he had not been harmed. Shortly after changing its position in this suit, the DOJ also issued a press release, which plainly announced that “the Department of Justice determined that multiple layers of removal restrictions shielding administrative law judges are unconstitutional.”

The court began its analysis of whether Lemelson had been “harmed” by pointing to Supreme Court precedent that held “where plaintiffs showed no harm stemming from similar removal protections, there was no basis for concluding that an agency lacked the authority to carry out its functions and thus no unlawful action to remedy.” Here, the court found that Lemelson had “not plausibly alleged facts” showing that ALJ tenure protections caused him any harm. Lemelson argued that at this stage of litigation (before discovery or trial) he had no obligation to “prove” that ALJ tenure protection caused him harm. The court, however, rejected this argument and held that this does not free him of the “obligation to allege such harm” and dismissed the claim under Rule 12(b)(6).

Unlike the other constitutional challenges raised by Lemelson, the court did not reach the Article II issue. In doing so, the court was in accord with the “longstanding principle of judicial restraint [that] requires that courts avoid reaching constitutional questions in advance of the necessity of deciding them.” As such, the question of the constitutionality of ALJ tenure protection remains undecided.

Key Takeaways

  • At least for the time being, the SEC has rebuffed a serious challenge to its in-house courts, and these courts now rest on more solid ground. This decision provides a measure of certainty that its in-house courts can continue to function, especially in the context of follow-on proceedings. The court brought to bear a significant amount of precedent to support the legitimacy of follow-on proceedings without addressing the Article II challenge to ALJ tenure protection.
  • It’s unlikely, however, that this will be the end of the story. Each step of the SEC’s litigation with Lemelson has been hotly contested, and it’s plausible that he will appeal this decision to the D.C. Circuit and possibly beyond. The SEC administrative courts also likely will continue to experience constitutional challenges in other cases until either Congress or the Supreme Court settles these questions.
  • The constitutional challenge to ALJ tenure protection still looms large over SEC in-house courts. Even though the Trump administration announced that tenure protection is unconstitutional, it recently opposed a petition for a writ of certiorari in another case related to an Article II challenge on the grounds that the case was “an especially poor vehicle for review.” This suggests that the DOJ is waiting for the “right” case to argue that the Supreme Court should hold that the appointment structure for SEC ALJs is unconstitutional.

 

[1] A follow-on proceeding is an SEC administrative action that “allows the SEC to suspend or bar someone if it finds on the record after notice and opportunity for hearing that (1) such a suspension or bar is in the public interest, and (2) that the person has been convicted of certain crimes or has been enjoined from any action, conduct, or practice” related to the federal securities laws.

[2] An associational bar is an SEC administrative bar that restricts a person from association with any investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization pursuant to Section 15(b)(6) of the Securities Exchange Act of 1934 or Section 203(f) of the Investment Advisers Act of 1940.

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