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# Hobson's CHOICE: The Financial CHOICE Act of 2017 and the Future of SEC Administrative Enforcement

## by John C. Coffee, Jr.

The Financial CHOICE Act of 2017 has now passed the House of Representatives on a strict party-line vote (winning not a single Democratic vote), but its prospects in the Senate seem dim.  Nonetheless, a fair chance exists that individual provisions of this bill will make it through the Senate in one or more watered-down compromises.  But which provisions?  In terms of its impact on SEC enforcement, the CHOICE Act is an oddly mixed bag.  Some sections could cripple the SEC, but at least one would empower it significantly.  Let’s begin by looking at the provisions of the CHOICE Act that affect SEC enforcement, but then I will turn more generally to recent Supreme Court decisions, which raise the prospect that administrative enforcement could be even more sharply curtailed in the near future by the Court.  Overall, SEC enforcement is under legal and political attack, and the Commission must be careful not to allow setbacks on one front to injure it on the other.

Time is short, so I will focus on only a few sections of the CHOICE Act.  I will analyze these in order of relative significance, beginning with Section 823.

## A. The Choice Act

              - Section 823: (“Private Parties Authorized to Compel the Commission to Seek Sanctions by Filing Civil Actions”) .  Section 823 of the CHOICE Act would entitle a defendant charged in a SEC administrative proceeding to require the SEC to move the proceedings to federal court. [1]   I suspect that the vast majority of defendants so charged would so opt—if only to slow the pace down, gain greater discovery, obtain a right to a jury trial (in some cases), and avoid administrative law judges (whose impartiality they doubt).  The SEC is severely resource constrained, and administrative proceedings permit the SEC to litigate at lower cost, more quickly, and closer to home (and thus away from more hostile courts and juries in “red” states).  SEC administrative actions can be resolved in months, but civil actions in court may take years.  The slower the SEC must go, the more the number of wrongdoers who escape sanctions.  Although there are constitutional issues surrounding the SEC’s use of administrative proceedings, these issues do not involve questions of due process, but rather issues of executive power (namely, the Appointments Clause of the U.S. Constitution).  Sooner or later, a Supreme Court resolution of this Appointment Clause issue appears highly probable (to which issue I will return shortly). [2]  The SEC’s dependence on administrative proceedings is best shown by two statistics: First, in fiscal 2016, the SEC initiated 868 enforcement proceedings, of which 692 (or roughly 80 percent) were administrative proceedings.[3]  Of course, many of these proceedings involved smaller matters (such as late filings), but that is no longer the consistent pattern.  Insider trading cases are today often brought administratively.  One measure of this is shown by looking specifically at public company related defendants.  In fiscal 2016, the SEC brought 90 percent of such actions as administrative proceedings (while in 2010, it brought only 34 percent of such proceedings administratively).[4]  This is a marked change.  If the SEC were denied administrative proceedings, it would seem compelled to cut back the total number of actions it could bring by a large percentage.[5]  **New Standard.**  Even if a defendant opts to stay in the administrative proceeding, Section 823 also raises the standard that the SEC must satisfy to that of “clear and convincing evidence.”  This is a standard usually reserved for proceedings involving the loss of civil liberties, rather than simply a monetary judgment.  It adds another unnecessary obstacle to the SEC’s ability to enforce the federal securities law.
              - Section 824: (“Certain Findings Required to Approve Civil Money Penalties Against Insurers”).   This Section would add a new Section 4F to the Securities Exchange Act of 1934, which would require the Division of Economic and Risk Analysis to make two findings (which would have to be certified by the SEC’s Chief Economist)  before  the SEC could seek a money penalty against an issuer.  Specifically, that Division would have to make findings as to whether: “(1) the alleged violation resulted in direct economic benefit to the issuer; and   (2) the penalty will harm the shareholders of the issuer.”  Presumably, the second finding is automatic: Any penalty, even if modest, is borne by the corporation’s shareholders.  To be sure, the SEC’s Staff has sometimes argued that a penalty alerts shareholders to corporate governance problems (and thereby benefits them),[6] but this is Orwellian doubletalk that few courts will take seriously.  In contrast, the first finding is more problematic.  Suppose the corporate issuer made payments in clear violation of the Foreign Corrupt Practices Act (i.e., bribes to an official in some foreign country to obtain business), but it did not win the business sought.  Some rival company paid more.  Hence, the U.S. issuer never received any “direct economic benefit.”  Here, it would be hard for the Division to make a finding of “direct economic benefit,” even though the conduct was clearly culpable.               Perhaps this seems a rare case.  But other cases are easily imaginable: suppose an issuer fails to disclose substantial liabilities over a nine month period; then, when disclosure is finally made, its stock price falls 25 percent.  Still, over this interval, no shares were issued or exchanged by the issuer.  As a result, although shareholders who purchased in the class period lost money, the corporation itself incurred no “direct economic benefit.”  An inflated stock price produces a “direct economic benefit” only if a transaction occurs at an inflated price.  Cases in which there was no “direct economic benefit” to the issuer could thus be very common.              Technically, Section 824 requires only that the Commission not seek or impose a “civil money penalty” against an issuer without first making findings on these two issues, but it does not require that the findings be affirmative.  That is, the Commission could publicly disclose in a given case that there was no “direct economic benefit” to the issuer and that the penalty will harm the issuer’s shareholders—and still proceed with its action.  What then is the point?  Perhaps, the provision is intended to embarrass or deter the Commission and its Staff in such cases.  Or perhaps, the thought is that the court hearing this action will react negatively to such findings and be more likely to dismiss the action or soften the penalties that it will impose.  Section 824 thus relies on Section 823’s de facto abolition of administrative proceedings, because it is less likely that an administrative law judge would be similarly moved by these findings.              The likely impact of Section 824 is uncertain, unless the draftsmen really intended that the Commission could not proceed as a matter of law in the absence of affirmative findings on both issues (which position the proposed statutory language certainly does not express).  Possibly, the Commission can counter this impact.  For example, even if the Commission would often be required to find that the issuer received no “direct economic benefit” and shareholders would be harmed by a penalty, it could still make additional findings that the conduct was culpable and dangerous and needed to be deterred.  Traditionally, public enforcement, in contrast to private enforcement, focuses on risk creation, not the gain to the issuer or the loss to shareholders. 
              - Section 825: (Officer and Director Bars ).  Section 825 would also repeal the SEC’s existing authority in an administrative proceeding to bar defendant individuals from serving as officers or directors of a “reporting” company.  The Commission would retain the authority to ask a federal court to bar a defendant from serving as an officer or director of a “reporting” company under Section 21(d)(2), but would lose its authority to do the same administratively under each of Section 8A(f) of the Securities Act of 1933 and Section 21C(f) of the Securities Exchange Act of 1934.  In this light, the significance of Section 825 depends again on the fate of Section 823.  If the defendant can always escape an in-house administrative proceeding under Section 823, the SEC’s powers in such an administrative proceeding are not very important.  Curiously, however, if the defendant could only be barred in a judicial proceeding, this might give the defendant some marginal motivation to remain in the in-house administrative proceeding.
              - Section 827: (“Elimination of Automatic Disqualifications”).   The SEC’s rules have long had a number of “bad boy” provisions under which an issuer no longer qualifies for certain exemptions once it has been convicted of a crime or settled with the SEC. [7]   In recent years, the Commission has sometimes waived these disqualifiers (and sometimes not).  This issue has been contentious, as some Commissioners believe, for example, that an issuer convicted of a felony does not deserve the Commission’s special consideration and that any waiver in such a case undercuts the stigmatization that should be associated with such a conviction (or other settlement).  Nonetheless, Section 827 will resolve this issue by eliminating automatic disqualification and forcing the Commission to take action by a Commission vote if it wishes to impose “bad boy” sanctions on such a corporation.
              - Section 828 (“Denial of Awards to Culpable Whistle Blowers”).   The SEC has had great success with its program to pay bounties to whistle blowers.  Nonetheless, Section 828 would amend Section 21F of the Securities Exchange Act to deny bounties to any whistle blower who was responsible for, or complicit in, the misconduct.  This might be understandable in the case of co-conspirators, but revised Section 21F(c) will now broadly define a person to be responsible for, or complicit in, a violation if the person: “(C) having a duty to prevent the violation, fails to make an effort the person is required to make.”  Passivity would now make you complicit.  This definition also does not tell us under what body or bodies of law might impose a duty to make “an effort.”  Suppose, for example, that the corporation’s bylaws require upward reporting by corporate officers and employees to the audit committee.  Does this impose such a duty for purposes of §828?  Also, current SEC rules (which seemingly have never been enforced) require an attorney “practicing before the Commission” to report violations of law or fiduciary breaches to the issuer’s audit committee.[8]  The problem here is that a subordinate who does not promptly report on a superior may have been intimidated into silence.  Yet, such persons will be disqualified from receiving any bounty, and this could chill the incentive to later blow the whistle.  Subordinates should not be seen as complicit wrongdoers simply because they do not behave as heroes. 
              - Wells Notice Appeals .   Section 821 creates a new procedure surrounding Wells notices under which the individual so notified “shall have the right to make an in-person presentation before the Commission staff concerning such recommendation and to be represented by counsel at such presentation.”  Nothing is said about what consequences will follow if only a few staff aides show up at this presentation (and a low rate of attendance seems likely).  Traditionally, the Wells process provided an occasion for quiet negotiation, but Section 821 would change that occasion into an opportunity for the aggrieved defendant to confront his accusers and berate them.  Fortunately, the Commissioners are not required to attend this proceeding, but they must receive a report setting forth all factual and legal arguments made by the defendant (and conceivably this right may give rise to a procedural challenge to the Commission’s eventual order).  Few outcomes will be changed by this new procedure (if it is adopted), but much time will be expended to give the defendant a chance to vent.  If the Commissioners’ aides are required to attend these therapeutic appeals, they should hold out for a higher salary.
              - Section 211 (“Enhancement of Civil Penalties for Securities Law Violations”) .  This section marginally increases the “money penalties” obtainable by the SEC in both administrative and civil actions, but then provides a new maximum penalty in cases involving “fraud, deceit, manipulation, or deliberate reckless disregard of a regulatory requirement,” which will be the greater of “3 times the gross amount of the pecuniary gain to the person who committed the act or omission” or “the amount of losses incurred by victims as a result of the act or omission.”  This last clause allows the SEC to seek full compensatory losses and not simply disgorgement.  To illustrate the significance of this step, consider these facts: An insider trades unlawfully on material nonpublic information on two dates and incurs a gain of $150,000, but on those same two dates, sellers trading in the market contemporaneously incur losses of $5,000,000.  Under this provision, the SEC can seek the greater of three times the gain ($450,000) or $5 million.  In cases where the corporation failed to disclose material information for a year, the investor losses could easily exceed $1 billion.

This is a huge change, and one wonders if the draftsmen of the House Bill knew what they were doing.

##  B. The Future Of Administrative Enforcement

The CHOICE Act is not the only adverse omen for the future of administrative enforcement.  In *Kokesh v. S.E.C.*,[9] the Court earlier this month held—unsurprisingly and unanimously—that the five-year statute of limitations in 28 U.S.C. §2462 applies to SEC efforts to obtain disgorgement.  Most could see this outcome coming (except at the SEC), but, buried in this opinion, is a footnote written by Justice Sotomayor (no libertarian conservative, she), which observes:

“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.”[10]

If the SEC lacks such authority or has used an incorrect methodology, it is in serious trouble.  Although it is dangerous to overread the tea leaves, this footnote may hint that some on the Court doubt that a non-Article III tribunal can award disgorgement or even that they believe that in a proceeding seeking a penalty the defendant is entitled to a jury trial.

            Equally ominous is the Court’s grant of certiorari last week in *Oil States Energy Services, LLC v. Greene’s Energy Group, LLC*,[11] which will address whether administrative proceedings at the United States Patent and Trademark Office properly comport with Article III and the Seventh Amendment (which guarantees citizens a right to a jury trial in proceedings at common law).  It is way too early to predict the outcome in this action.  But if the Court is concerned that administrative proceedings eclipse the citizen’s right to a jury trial, the SEC is again in serious trouble.  Historically, the Court has permitted Congress to designate “public rights” for adjudication before non-Article III tribunals and without the right to a jury trial.  If the Court were to narrow its definition of “public rights,” a period of considerable constitutional uncertainty will follow.

            As noted earlier, the Court is today under legal and political attack.  In 2015, the Chamber of Commerce published a lengthy attack on SEC administrative enforcement that largely mirrors the CHOICE Act.[12]  The leading criticism from both the Chamber and the defense bar is that SEC administrative law judges are biased in favor of the agency.  Although this claim could support a due process challenge, this is the one area where the SEC is unlikely to lose in court, if only because over forty federal agencies (and an unknown, but larger, number at the state level) use administrative law judges.  Where the SEC could easily lose in court is on the Appointments Clause issue.  Currently, the SEC’s Chief Administrative Judge is the predominant decision-maker who appoints the SEC ALJs, and this could violate the Appointments Clause, which requires the Head of the Department to appoint “inferior officers.”  The SEC claims that its ALJs are not “inferior officers,” but mere employees.  Here, precedent suggests that the SEC is destined to lose (either in the D.C. Circuit where an en banc case is now pending or at the Supreme Court).[13]  If that happened, the public or Congress might misunderstand such a loss as a judicial finding that administrative proceedings are unconstitutional.

            What should the SEC do?  Here comes advice that the Commission will not follow—until it is too late.  The simplest, most practical solution would be for the SEC’s Commissioners to reappoint all its existing ALJs, in effect confirming the Chief Administrative Judge’s earlier appointments.  Then, each ALJ, now safely appointed in a constitutionally proper way, could reconfirm all his or her rulings in pending cases (without any new hearing being necessary).  This sidesteps the narrow constitutional issue and should reduce the prospect of a grant of certiorari based on the Appointment Clause.[14]  The Commission could also maintain the Chief ALJ’s role in this process by agreeing to have her make nominations for ALJ positions (and generally deferring to her nominations).  This would mitigate the due process issue that the SEC was appointing the judges who reviewed its own conduct.

            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).  Worse yet, the Commission has more to lose in litigation over the Appointments Clause than in *Kokesh*.  A five year statute of limitations will not cripple it, but many decisions, now on appeal, might be overturned if the Appointments Clause is found to have been violated.  Also, this proposed reform has low costs.  If the Commission appointed its own ALJs on nomination by its Chief Administrative Judge, no principle is compromised.  Sometimes, the Commission has to recognize that discretion is the better part of valor.

            To be sure, the Commission has taken some modest steps to appease its critics in the defense bar.  It has amended its Rules of Practice to allow some depositions (3 to 5) and to give the defendant more time for preparation.  Good for it!  But further steps may be necessary to counteract the common perception that the Commission has too much of a “home court” advantage in administrative proceedings.  Little more can be said about the future until the Supreme Court tells us what it is thinking about administrative enforcement.

----

* Professor Coffee is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

----

[1] Technically, Section 823 would add a new Section 41 to the Securities Exchange Act of 1934.

[2] Compare *Bandmere v. SEC*, 844 F. 3d 1168 (10th Cir. 2016) (finding procedure to violate Appointments Clause Constitution) with *Raymond J. Lucia Cos. v. SEC*, 832 F. 3d 277 (D.C. Cir. 2016)(contra).

[3] See Securities and Exchange Commission, “Select SEC and Market Data, Fiscal 2016,” available at hptts://www.sec.gov/files/2017-03/secstats2016.pdf

[4] See Securities Enforcement Empirical Database (SEED), “SEC Enforcement Activity against Public Companies and their Subsidiaries—Fiscal Year 2016 Update” (2016), available at http://www.law.nyu.edu/sites/default/files/SECEnforcement-Activity-fy2016-updated.pdf.

[5] One consequence would probably be the end of the SEC’s “Broken Windows” policy under which the SEC seeks to take enforcement actions in most smaller cases.  I have long thought this policy overly ambitious.  The less visible consequence may be a need to settle major cases modestly, which has long been a tendency at the SEC that Judge Rakoff and others have decried.

[6]  See *SEC v. Bank of Am. Corp.*, 2009 U.S. Dist. LEXIS 82303 at * 2- * 3 (S.D.N.Y August 25, 2009). Although the SEC eventually won this battle, it lost the war to Judge Rakoff’s critique, and it suffered lasting reputational injury.

[7] For the original example of a “bad boy” provision, see SEC Rule 262, 17 C.F.R. §230.262 (disqualifying issuers from access to Regulation A under certain conditions).

[8] See “Standards of Professional Conduct for Attorneys Appearing and Practicing Before the Commission in the Representation of an Issuer,” 17 C.F.R. §205 at Rule 3.

[9] 2017 U.S. LEXIS 3557, 2017 WL 2407471 (June 5, 2017).

[10] 2017 U.S. LEXIS 3557 at *10n.3

[11] See *Oil States Energy Servs. v. Greene’s Energy Group*, 2017 U.S. LEXIS 3727 (June 17, 2017) (granting certiorari on first issue limited to Article III and the Seventh Amendment).  The case involves whether the USPTO’s “inter pares” review of a patent challenge required the agency to use an Article III tribunal and permit the claimant to opt for a jury trial. This is a decidedly curious case to use as a vehicle because the issue here is whether the USPTO should reverse its earlier decision as to patentability, which is not the type of “common law” dispute where an Article III tribunal might most easily be required.

[12] See Center for Capital Market Competitiveness, “Examining U.S. Securities and Exchange Commission Enforcement” (July 2015).

[13] The leading modern case is *Freytag v. Commissioner*,501 U.S. 868 (1991), in which the Court found that a “special trial judge” at the Tax Court who was  appointed by that Court’s Chief Judge was an “inferior officer” and not a mere “employee.” Distinctions between cases can always be drawn, but the role and status of an ALJ seems quite similar.

[14] If the SEC loses its pending *en banc*case in the D.C. Circuit (see supra note 2), it should take this ratification step, rather than seek certiorari. Even if it wins (which would leave the Circuits split and certiorari likely), it should similarly cure its vulnerability by the simple act of ratification.

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