Timber! the Sec Falls Hard as the Georgia District Court in Timbervest Finds the Appointment of the Sec Aljs "likely Unconstitutional"

• Citation: Vol. 67 No. 2
• Publication year: 2016

Timber! The SEC Falls Hard as the Georgia District Court in Timbervest Finds the Appointment of the SEC ALJs "Likely Unconstitutional"

Moses M. Tincher

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Timber! The SEC Falls Hard as the Georgia District Court in Timbervest Finds the Appointment of the SEC ALJs "Likely Unconstitutional"^†

I. Introduction

The higher you go, the harder you fall. This simple, yet powerful, adage could not be more apt regarding the recent rise and fall in power of the United States Securities and Exchange Commission (SEC). The rise began in 2010 when Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),¹ giving the SEC

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new power over its administrative proceedings.² Using this new power, the SEC brought more insider-trading and highly contested cases before specially hired administrative law judges (ALJs),³ who conduct these administrative proceedings.⁴ This "home-court" advantage corresponded with the SEC's enforcement division enjoying an 86%, success rate in administrative proceedings over the past five years, compared to only a 70% success rate in federal courts.⁵

With this increased success, the SEC has faced strong opposition from various investment advisory groups.⁶ Specifically, these groups have raised multiple district court challenges to the SEC's hearing process, including one particularly innovative challenge in Timberuest v. SEC.⁷ In this 2015 case, the plaintiffs alleged, among other things,⁸ that the SEC's appointment process for its ALJs is unconstitutional.⁹ Judge May of the United States District Court for the Northern District of Georgia agreed and found that the SEC's appointment of ALJs likely violates Article II of the United States Constitution,¹⁰ because ALJs are inferior officers, not mere employees.¹¹ As inferior officers, ALJs must be appointed by the President, the courts of law, or the heads of departments.¹² The SEC ALJs are not appointed by any of these parties.¹³

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Therefore, as one of the first cases with which a federal district court judge has agreed regarding constitutional challenges to the SEC ALJ appointment, Timbervest creates significant ramifications for the SEC and, potentially, all other federal agencies that use ALJs.

II. Factual Background

Plaintiff Timbervest, LLC (Timbervest) is a registered investment advisor, managing timberland and other environmental assets for various investment funds.¹⁴ Timbervest manages three comingled timberland funds and three commingled environmental funds.¹⁵

In 2010, the SEC's Division of Enforcement began investigating Timbervest's policies and methods for measuring timberland properties. Three years later, the SEC initiated an enforcement action against Timbervest, serving it with an "Order Instituting Cease-and-Desist Proceedings."¹⁶ The SEC alleged that Timbervest violated Sections 206(1)¹⁷ and 206(2)¹⁸ of the Investment Advisers Act for two reasons: (1) it failed to disclose fees earned in the sale of two properties; and (2) it sold one of the properties to a third party and later repurchased the property through a different Timbervest fund.¹⁹

After a formal administrative hearing, ALJ Elliot ruled in favor of the SEC, stating that Timbervest violated §§ 206(1) and (2) of the Investment Advisers Act and that the individual plaintiffs aided and abetted in causing these violations. Timbervest appealed ALJ Elliot's decision to the SEC commissioners, arguing that the evidence did not support the ALJ's findings, and that due to the ALJ's bias in favor of the SEC, the SEC's administrative forum was unconstitutional.²⁰

Shortly before the parties' oral argument, the Wall Street Journal published an article entitled, "SEC Wins With In-House Judges."²¹ In this article, a former SEC ALJ, Judge McEwen, described the unfairness

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inherent in SEC administrative proceedings.²² Judge McEwen alleged that she felt pressured to rule in favor of the SEC and that Chief Judge Murray had questioned Judge McEwen's loyalty to the SEC whenever she ruled in favor of the defendants in previous cases. She also stated that the SEC instructed her to work under the presumption that the defendants were guilty until proven innocent. Because these statements were relevant to its due process claim pending before the SEC commissioners, Timbervest demanded the SEC to produce evidence relating to Judge McEwen's allegations.²³

In addition, Timbervest later discovered that the SEC had admitted its commissioners did not appoint ALJ Elliot.²⁴ Timbervest asked the SEC to produce information relating to ALJ Elliot's appointment. The SEC staff produced an affidavit stating that the SEC commissioners did not appoint ALJ Elliot; rather, the SEC's head ALJ appointed him. On that same day, the SEC asked ALJ Elliot to file an affidavit to address the question of whether he experienced any pressure or was biased in favor of the SEC. Soon after, the SEC's secretary notified Timbervest that ALJ Elliot refused to submit the affidavit.²⁵

Failing to find relief in the administrative forum, Timbervest filed a motion for a Temporary Restraining Order and Preliminary Injunction in the United States District Court for the Northern District of Georgia on June 12, 2015. Timbervest specifically asked the court to declare the SEC's appointment and removal process for its ALJs as unconstitutional.²⁶ On August 4, 2015, the court denied Timbervest's motion because the administrative hearing had already occurred.²⁷ Nonetheless, while the court chose not to address Timbervest's removal claim, it concluded that Timbervest would have likely prevailed on the merits of the appointment claim.²⁸ The court reasoned that the SEC ALJs are inferior officers, not merely employees; therefore, because it violated the

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Appointments Clause,²⁹ the SEC ALJs' appointment was "likely unconstitutional."³⁰

Following the district court's decision, the SEC commissioners heard an interlocutory appeal in the administrative proceeding regarding whether the SEC ALJs were inferior officers.³¹ In a four to one ruling, the commissioners concluded that the SEC ALJs were mere employees, not inferior officers.³² However, the dissent suggested that the judiciary should resolve the issue rather than the SEC.³³

III. Legal Background

A. The Role of ALJs

In general, ALJs are selected by federal agencies "as . . . necessary" to conduct administrative proceedings.³⁴ While ALJs provide initial decisions that establish factual findings, ALJs have limited authority to make final decisions.³⁵ Moreover, the agency heads supervise ALJs,³⁶ such that they have the authority to reverse ALJs' decisions in full, as to both fact and law.³⁷ The agencies, however, must award some deference to the ALJs' initial decision in administrative appeal.³⁸

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If an agency disagrees with the ALJ's initial decision, the agency has authority to remove that ALJ only for "good cause established and determined by the Merit Systems Protection Board. . . ."³⁹ An example of what constitutes "good cause" is insubordination; however, the MSPB has not clearly defined how much insubordination an agency must show to justify removing an ALJ.⁴⁰ This ambiguity of the good cause standard, as well as the ALJs' limited independence in final decision making, have created concerns with respect to the justice rendered in administrative proceedings.⁴¹ Because ALJs apply agency regulations and policy, they cannot be entirely unbiased.⁴² Nonetheless, since the enactment of the Dodd-Frank Act, ALJs from one agency in particular, the SEC, have collectively ruled in favor of the SEC, rekindling the impartiality concern.⁴³

B. The SEC and the Dodd-Frank Act

The SEC is one of many independent federal agencies that uses ALJs for its administrative proceedings.⁴⁴ The SEC was established through a series of legislative acts.⁴⁵ Specifically, as a result of the Great Depression, Congress passed—and President Franklin Roosevelt signed into law—the Securities Act of 1933,⁴⁶ which was the first federal law to regulate the sale of securities to investors.⁴⁷ The following year, Congress created the SEC, with which corporations registered securities.⁴⁸ Furthermore, the Securities Act of 1933 required the SEC to

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approve an issuer's "registration statement" before the securities could be sold to investors.⁴⁹

Although this system prevented the most egregious abuses, a number of investment banking and securities management groups were able to defraud their investors.⁵⁰ A number of high profile securities fraud cases, along with the financial crisis of 2008, transformed the political landscape, compelling Congress to enact new legislation.⁵¹ In 2010, Congress passed the Dodd-Frank Act, which limited the risk of financial as well as securities fraud,⁵² while significantly expanding the SEC's powers.⁵³

Prior to the Dodd-Frank Act, the SEC could bring claims against persons or entities registered with the SEC in administrative proceedings.⁵⁴ However, for those persons and entities that were unregistered, the SEC had to file its claims in federal court.⁵⁵ Pursuant to the Dodd-Frank Act, the SEC can now use the administrative process to impose fines and penalties on any person or entity-both those registered and unregistered with the SEC.⁵⁶ In short, the Dodd-Frank Act significantly expanded the SEC's ability to proceed administratively.⁵⁷ Plaintiffs responded to this expansion by challenging aspects of the SEC's administrative process, including whether the SEC's appointment and removal procedures are constitutional.⁵⁸

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C. Appointments Clause

The Appointments Clause governs the appointment of all "officers of the United States."⁵⁹ These officers exercise "significant authority pursuant to the laws of the United States"⁶⁰ and fall into one of two categories: principal and inferior officers.⁶¹ While principal officers must be appointed by the President with the advice and consent of the...