United States: SEC Approves Amendments To Rules Of Practice, Making Welcome But Incremental Changes To Enforcement Procedures

On July 13, the Securities and Exchange Commission approved the adoption of amendments to the Rules of Practice that govern its administrative proceedings. The approval was announced with little fanfare eight months after the Dec. 4, 2015, closure of the period for public comment, although the amendments are largely consistent with the Commission's original proposals, adopting most "as proposed" or "substantially as proposed."1 Most prominently, the amendments potentially lengthen the prehearing stage of administrative proceedings, permit some depositions as a matter of right for each side in complex proceedings and explicitly provide for the exclusion of "unreliable" evidence. The amendments will apply to all proceedings initiated 60 days or more after their publication in the Federal Register, and apply to some pending actions, depending on the phase of the proceeding.

The amendments arrive amid a steady stream of legal challenges to the Commission's increased use of its in-house forum following the passage of the Dodd-Frank legislation in 2010. Dodd-Frank authorized the Commission to impose monetary penalties in administrative proceedings on persons not associated with entities registered with the Commission; prior to Dodd-Frank, only the federal courts had this power. This change, as well as the Commission's enhanced authority to bar persons from the securities industry in administrative proceedings (also granted by Dodd-Frank), has contributed to a significant spike in the Commission's use of the in-house forum. Moreover, where in the past the Commission, even as to regulated persons, had tended to sue in federal court on complex matters, such as insider trading violations, more recently it has sued administratively in such cases as well. The Commission's increased utilization of its in-house forum has unfavorably highlighted the differences between proceedings in that forum and in the federal district courts. The disparity in the Commission's rate of winning verdicts — 90% in contested cases pursued in-house, compared with 69% in federal court — has also raised eyebrows.2

Notably, in an SEC administrative proceeding, there is only limited document discovery and no deposition discovery; review of the administrative law judge's (ALJ) tentative decision goes to the commissioners, who themselves approved the original filing of the proceeding; and an appeal of the Commission's order is made to a federal court of appeals whose review is deferential to the Commission's findings. In contrast, in a district court proceeding, the action is conducted before an Article III federal judge, there is a right to a jury trial, there is plenary discovery under the Federal Rules of Civil Procedure and the Federal Rules of Evidence apply.

Beginning with Gupta v. SEC in 2011,3 litigants have argued that the Commission's administrative proceedings suffer from a number of constitutional deficiencies. These include violations of the due process clause (the SEC's administrative procedures are inadequate), the equal protection clause (see, e.g., Gupta, where Judge Jed Rakoff denied the Commission's motion to dismiss Mr. Gupta's complaint, citing a "well-developed public record of Gupta being treated substantially disparately from 28 essentially identical defendants [who were charged in federal district court]") and the appointments clause (claiming that ALJs are "inferior officers" and must under the Constitution be appointed by the president or "Heads of Departments").

The Commission has responded with incremental reform. In May 2015, the Commission's Enforcement Division issued formal guidance on the factors it will consider when choosing between instituting proceedings in-house or in federal court. However, those factors centered on the Commission's convenience and enforcement priorities, as opposed to the fairness to the respondent. The Commission's recent approval of the amendments to the Rules of Practice seems to be an attempt to address specific criticisms of the in-house procedures, while leaving broader criticisms to the side. Although commenters, according to the Commission, "generally supported the Commission's efforts to update the rules, expand the discovery process and enlarge the timetables in administrative proceedings," some "argued that the proposed amendments were too incremental," while others questioned "the legitimacy of the Commission's administrative forum" altogether.

A number of the amendments are noteworthy:

  • Rule 360, which concerns the timing for the stages of administrative proceedings, more than doubles the maximum prehearing period — the period between service of the order instituting proceedings (OIP) and the start of hearings — to 10 months for complex cases.4 According to the Commission, the "longer prehearing period is intended to provide parties, in appropriate cases, additional time to review the investigative record, conduct depositions under amended Rule 233, and prepare for a hearing," although the Commission "recognize[s] that some might view the maximum ten-month prehearing period as not long enough." To take account of the potentially longer prehearing period, the amended Rule scraps the former requirement that the hearing officer's initial decision be filed within 300 days from the date of service of the OIP, and instead sets the date for the initial decision at 120 days after one of multiple events that occur later — e.g., the completion of post-hearing briefing — with the potential for a 30-day extension.5
  • Rule 233 governs depositionsand had previously provided that any party could move for permission to take the deposition of a witness likely to be unavailable to testify at a hearing. The rule thus did not envision "discovery-type" depositions. The amended rule retains this provisionbut also allows for respondents and the Commission's Enforcement Division to take discovery-type depositions in complex cases. In a single-respondent proceeding, each side will be permitted to notice the depositions of three persons as of right. In a multirespondent proceeding, the Enforcement Division will be entitled to notice the depositions of five persons, while the respondents collectively will be entitled to notice the depositions of five persons. Either side can move for leave to notice up to two additional depositions. Most commenters sought even more depositions, but in the Commission's view, the amendments "provide parties with the potential benefits of deposition discovery without sacrificing the public interest or the Commission's goal of resolving administrative proceedings promptly and efficiently."
  • Rule 320, which sets the standards for admissibility of evidence at hearings, had prescribed the exclusion of "irrelevant, immaterial, or unduly repetitious" evidence. The amended rule adds "unreliable" evidence to that list, but also provides that hearsay may be admitted if it is "relevant, material, and bears satisfactory indicia of reliability so that its use is fair." Although most commenters sought full incorporation of the hearsay rules from the Federal Rules of Evidence, the Commission "continue[s] to believe that a case-by-case determination of the admissibility of hearsay evidence is more appropriate than . . .broad exclusionary rules," as well as being consistent with the Administrative Procedures Act.

While many of the amendments will be welcomed by defense practitioners (even if they are viewed as not going far enough in the right direction), not all of them favor respondents. For example, Rule 220 introduces a new requirement that a respondent must affirmatively state in her or his answer whether the respondent intends to assert a reliance-on-counsel defense.6 Commenters argued that the requirement "prejudices respondents, provides an unfair advantage to Division staff in administrative proceedings, improperly requires respondents to disclose their trial strategy, and infringes on the attorney work-product privilege." The amendment was nevertheless adopted "substantially as proposed."7

Although the new amendments are generally a step in the right direction, they of course do not give respondents the same procedural protections as trials in federal court, and they fail to address the more fundamental criticisms of the Commission's administrative forum. Commenters opposed the administrative forum on the grounds that the "Commission will choose to shield controversial cases from the full scrutiny of federal district and appellate courts" and that"conflicts of interest preclude the Commission from being perceived as a neutral arbiter." However, the Commission determined that these comments, as well as a recommendation that the Commission create a procedure for respondents to remove certain cases to federal court, were "outside the scope of the proposed amendments" and did not address them.

Given Dodd-Frank's expansion of the Commission's penalty authority and the Commission's increasing reliance on the administrative forum, the recent amendments are unlikely to quiet critics and curtail legal challenges. In Gupta v. SEC, in the face of the respondent's Equal Protection claim of disparate treatment, Judge Rakoff denied the SEC's motion to dismiss, rejecting the Commission's arguments that Gupta's claims were barred by sovereign immunity and that he had to exhaust administrative remedies. The Commission then withdrew its administrative proceeding and later sued Mr. Gupta in federal court. More recent challenges have fared less well. Federal appellate courts in the 2nd, 7th, 11th and D.C. Circuits — dealing principally with appointments clause and due process challenges to the Commission's rules — have all recently held that such arguments must first be presented to the Commission before they can be considered by a federal court. But these jurisdictional setbacks do not extinguish — they merely delay — challenges to the constitutionality of the Commission's administrative proceedings. Indeed, the D.C. Circuit should rule on the merits of one such challenge shortly,8 another development to watch for in this ongoing saga.


1 Unless otherwise noted, all quotations are from the Commission's adopting release No. 34-78319.

2 See Jean Eaglesham, SEC Wins With In-House Judges, Wall St. J., May 6, 2015 ("The SEC won against 90% of defendants before its own judges in contested cases from October 2010 through March of this year, according to the Journal analysis. That was markedly higher than the 69% success the agency obtained against defendants in federal court over the same period, based on SEC data.") 

3 11-cv-01900 (S.D.N.Y. July 11, 2011). Kramer Levin Naftalis & Frankel represented Mr. Gupta in this action.

4 Under the amended rule, the least complex proceedings will have a prehearing period of no more than four months, and proceedings of medium complexity will have a prehearing period of no more than six months.

5 Under the amended rule, the least complex proceedings will have a 30-day deadline for initial decision, and proceedings of medium complexity will have a 75-day deadline.

6 The amendment also requires the respondent to state whether she or he relied upon the advice of accountants, auditors or other professionals.

7 The amendments also impact Rule 141 (Orders and Decisions; Service of Orders Instituting Proceedings and Other Orders and Decisions); Rule 161 (Extensions of Time, Postponements and Adjournments); Rule 180 (Sanctions); Rule 221 (Prehearing Conference); Rule 222 (Prehearing Submissions); Rule 230 (Enforcement and Disciplinary Proceedings: Availability of Documents for Inspection and Copying); Rule 232 (Subpoenas); Rule 234 (Depositions Upon Written Questions); Rule 235 (Introducing Prior Sworn Statements or Declarations); Rule 250 (Dispositive Motions); and certain rules of appellate procedure and the Rule 900 guidelines.

8 The case is Raymond J. Lucia Cos. v. SEC, 15-1345, and focuses on the Constitution's appointments clause.

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