Leave it to the SEC and the federal courts to turn this into a winter of discontent. As the frigid temperatures of 2017 fall upon us, Wall Street's legal community is trying to figure out whether the federal securities regulator is acting in a constitutional or unconstitutional manner. While we're pondering that prospect, we must further wonder whether the SEC's enforcement docket will be upended if cases adjudicated by the organization's administrative law judges must be overturned for constitutional infirmities. All of which adds up to one hell of a mess except for industry lawyers who may soon be enjoying one hell of a lovely payday!
Free Enterprise Fund and PCAOB
We are asked, however, to consider a new situation not yet encountered by the Court. The question is whether these separate layers of protection may be combined. May the President be restricted in his ability to remove a principal officer, who is in turn restricted in his ability to remove an inferior officer, even though that inferior officer determines the policy and enforces the laws of the United States?
We hold that such multilevel protection from removal is contrary to Article II's vesting of the executive power in the President. The President cannot "take Care that the Laws be faithfully executed" if he cannot oversee the faithfulness of the officers who execute them. Here the President cannot remove an officer who enjoys more than one level of good-cause protection, even if the President determines that the officer is neglecting his duties or discharging them improperly. That judgment is instead committed to another officer, who may or may not agree with the President's determination, and whom the President cannot remove simply because that officer disagrees with him. This contravenes the President's "constitutional obligation to ensure the faithful execution of the laws." Id., at 693.
SIDE BAR: For a detailed analysis of Free Enterprise Fund: Supreme Court Rules PCAOB Construct Partially Unconstitutional -- Terminable At Will Is New Standard (BrokeAndBroker.com Blog, June 28, 2010).
Entering into 2017, the SEC ALJ handling Kon announced that he followed the SEC's historic position of accepting the line of federal cases that had favorably interpreted the constitutionality of his service. To be clear, there is nothing wrong -- in principle or theory -- for any ALJ to espouse the company line. The problem create by this pick-and-choose approach is that at least one federal appellate court has ruled that the SEC's ALJs are serving in an unconstitutional manner; and that means that when a respondent in an SEC proceeding reiterates the holding of Bandimere, the SEC is confronted not with a mere respondent's argument but, to the contrary, a federal circuit court's finding.
ompare Bandimere v. SEC with Raymond J. Lucia Cos. v. SEC See Raymond J. Lucia Cos
1. This matter involves violations of the federal securities laws by Harding and its principal Wing F. Chau in their role as investment managers for certain collateralized debt obligation transactions ("CDOs"). As the Collateral Manager of these CDOs, Harding was responsible for the selection, acquisition, and monitoring of portfolios of assets - the collateral - backing tranches of securities issued to investors by special-purpose vehicles (the "Issuers"), including one named Octans I CDO Ltd. ("Octans I").
2. Unbeknownst to investors and in conflict with the marketing materials and offering circular for Octans I, a third party named Magnetar Capital LLC (together with affiliates, "Magnetar") - a hedge fund firm whose interests were not aligned with those of the debt investors in Octans I - had undisclosed rights over the selection of collateral for Octans I. Magnetar's influence led Harding to select assets for Octans I that Harding's own personnel disfavored.
3. The Octans I transaction was a $1.5 billion CDO that closed on September 26, 2006. The collateral for the transaction consisted mostly of credit default swaps ("CDS") referencing subprime residential mortgage-backed securities ("RMBS"), 1 as well as securities of other CDOs backed by RMBS. Octans I was structured and marketed by subsidiaries of Merrill Lynch & Co., Inc. (collectively "Merrill"), which also lent their balance sheet to store, or "warehouse," collateral acquired for Octans I in the months leading up to the closing of the transaction. By April 3, 2008, Octans I had failed, costing the transaction's outside investors approximately $1.1 billion. Harding received approximately $4.5 million in fees for its role in the transaction.
4. The warehouse agreement governing the process of accumulating collateral prior to the closing of the Octans I transaction was actually a three-way agreement among Harding, Merrill, and Magnetar. The agreement gave Magnetar important rights, chief of which was the right to veto Harding's selection of collateral for the Octans I portfolio. Consistent with the agreement, Magnetar exercised significant control over the composition of the portfolio, but this right, among the others granted to Magnetar, was not disclosed to the debt investors in Octans I.
5. The so-called "pitchbook" and offering circular used to market Octans I, the relevant portions of which were drafted or reviewed by Harding, described Harding's creditselection processes and represented that the collateral would be selected by Harding and housed at Merrill in accordance with a warehouse agreement between Merrill and Harding. These representations were materially misleading because they did not disclose Magnetar's rights in and influence over the collateral selection process.
6. The offering circular and a Collateral Management Agreement with the Octans I Issuer executed by Chau also represented that Harding, in selecting collateral for the CDO, would perform its obligations as collateral manager:
with reasonable care (i) using a degree of skill and attention no less than that which [Harding] would exercise with respect to comparable assets that it manages for itself and (ii) without limiting the foregoing, in a manner consistent with the customary standards, policies and procedures followed by institutional managers of national standing relating to assets of the nature and character of the [Octans I collateral].
This was a material misrepresentation in that Harding and Chau, as they knew or at least recklessly disregarded, compromised their standards to accommodate trades requested by Magnetar.
7. Harding and Chau also later breached their obligations by purchasing, for inclusion in several other CDOs managed by Harding, tens of millions of dollars' worth of notes from a troubled Magnetar-related CDO underwritten by Merrill known as Norma. Harding and Chau bought the Norma securities despite their basically unfavorable view of them, adding lower-rated notes to their prior Norma commitment only after receiving pressure from Merrill and a direct request from Magnetar. Chau was apparently trying to return a favor and show that he was a "team player" who "never forget[s] my true friends." For each of the CDOs into which Harding placed the Norma notes, the collateral management agreement contained standard of care representations similar to that in the collateral management agreement for Octans I.
8. Harding and Chau committed the breaches described in this Order because they wanted fees that could be earned only if Magnetar agreed to close the Octans I transaction, and because they were seeking to please Merrill and Magnetar. Merrill had arranged the Octans I transaction at the impetus and behest of Magnetar, which, together with Merrill, had selected Harding as the collateral manager. Merrill and Magnetar had sent, and were in a position to continue sending, significant CDO business to Harding. As such, Harding's interests were in keeping Merrill and Magnetar happy, and Harding put those interests ahead of its obligations to the Issuers and their investors.
Footnotes:SEC ALJ Initial Decision
1 RMBS are bonds backed by pools of residential mortgage loans, in this case subprime loans. CDS are explained below.
As noted in the Initial Decision's "Summary":SIDE BAR: I rank ALJ Elliot's Harding Advisory Initial Decision among the most comprehensive and thoughtful documents of its type. After some 35 years on Wall Street, I am compelled to characterize ALJ Elliot's effort as "towering" and would commend it to any serious industry participant. Whether you concur or disagree in whole or part with Elliot's findings and decisions, there should be no doubt as to the considerable effort and dedication that was behind this document.
Without question, the regulatory issues presented in Harding Advisory are serious. The proposed financial sanctions exceed $3 million and the ALJ proposes to bar Chau. As summarized in the Initial Decision, ALJ Elliot found that
This Initial Decision (ID) finds that Respondents Harding Advisory LLC (Harding) and Wing F. Chau (Chau) violated Section 17(a) of the Securities Act of 1933 (Securities Act) and Section 206 of the Investment Advisers Act of 1940 (Advisers Act). The ID: orders Harding and Chau to cease and desist from violations of Section 17(a) of the Securities Act and Section 206 of the Advisers Act, and to jointly and severally pay $1,003,216 in disgorgement and prejudgment interest; revokes Harding's investment adviser registration and orders it to pay a civil penalty of $1.7 million; and bars Chau from association with the securities industry and orders him to pay a civil penalty of $340,000.
[H]arding committed the following violations:
a. negligently misrepresenting to Octans I investors, in the pitch book, Harding's investment analysis process, in violation of Section 17(a)(2);b. negligently misrepresenting to the Octans I issuer, in the CMA, the standard of care Harding followed in selecting collateral, in violation of Section 206(2) and Section 17(a)(2);c. negligently failing to follow the correct standard of care, with respect to the Octans I issuer, in violation of Section 206(2) and Section 17(a)(3);d. negligently misrepresenting to Octans I investors, in the offering circular, the standard of care Harding followed in selecting collateral, in violation of Section 17(a)(2);e. failing to follow the correct standard of care, with respect to two advisory clients which received Norma mezzanine bonds, in violation of Section 206(1) and Section 17(a)(1); andf. misrepresenting to two advisory clients, in each client's CMA, the standard of care Harding followed in selecting Norma mezzanine bonds for each client's portfolio, in violation of Section 206(1) and Section 17(a)(1).
Pages 90 - 91 of the SEC Initial Decision
Additionally, Chau is primarily liable for, and aided and abetted and caused, Harding's Norma-related violations.
In setting forth their rationale for dismissing the Octans charges, the Chair and both Commissioners explain:
A registered investment adviser and its principal violated Section 17(a) of the Securities Act of 1933 and Sections 206(1) and (2) of the Investment Advisers Act of 1940 in selecting assets for certain collateralized debt obligations ("CDOs") that it managed. Held, it is in the public interest to bar principal with a right to reapply after five years for permission to associate, revoke the investment adviser's registration, order disgorgement of $5,775,635.61, plus prejudgment interest, jointly and severally, and order the investment adviser to pay two civil penalties of $425,000 each, or $850,000 total, and the principal to pay two civil penalties of $85,000 each, or $170,000 total.
Pages 6 -7 of the SEC Opinion
We dismiss all charges related to Octans. We agree with the ALJ, based on our independent de novo review, that the record does not support the Division's theory that Harding knowingly or recklessly compromised its independent judgment to select undesirable assets that favored Magnetar's short position. The record indicates that, despite modest short positions, Magnetar was net long in Octans and that its financial interests were generally aligned with other debt investors in the CDO. We also find that the omission of Magnetar's involvement in the warehouse agreement from the offering documents was not fraudulent. We find further that the Division failed to establish that Harding negligently misrepresented the standard of care it would follow in selecting assets for Octans. To the extent that the Division's expert witness articulated a standard of care, the record demonstrates that Harding satisfied that standard.
Pages 14 - 15 of the SEC Opinion
The record establishes that Respondents agreed to purchase the BBB-rated Norma tranche as a favor to Merrill and Magnetar and allocated those bonds to Lexington and Neo without regard for the creditworthiness of the assets. Accordingly, we find that Respondents abdicated their duty to pick only the assets they believed were best for their clients-the issuers of Lexington and Neo-in violation of Sections 206(1) and 206(2) of the Advisers Act. We also find that Respondents misrepresented the standard of care Harding would follow in selecting assets for Lexington and Neo in violation of Section 17(a)(2) of the Securities Act.
C. Respondents' challenges to appointment of Commission ALJs are unpersuasive
Respondents argue that the ALJ who presided over this matter was not appointed in a manner consistent with the Appointments Clause of Article II of the Constitution or applicable statutory provisions.81 We have rejected similar claims before and again do so here.82
Recently, the D.C. Circuit confirmed in Raymond J. Lucia Companies v. SEC that our ALJs are employees, not constitutional Officers, and thus their manner of appointment is not subject to the requirements of the Appointments Clause. The D.C. Circuit, relying on Landry v. FDIC, 83 rejected squarely the contention that the Commission's ALJs are "constitutional Officer[s] who must be appointed pursuant to the Appointments Clause."84 Lucia held that the "FDIC regime considered in Landry" does not differ in any material way from the regulatory regime governing our ALJs.85
As Lucia explained, "nothing in the securities laws . . . suggests Congress intended that Commission ALJs be appointed as if [constitutional] Officers."86 That the federal securities laws specify that only the Commission and "officers of the Commission designated by it" may exercise certain functions, such as issuing subpoenas and holding hearings, 87 is irrelevant. There is "no indication Congress intended these officers to be synonymous with 'Officers of the United States' under the Appointments Clause." 88 Identical reasoning disposes of Respondents' contention that we failed to adhere to our organic statutes or the Administrative Procedure Act, by authorizing ALJs, who are mere employees, to preside over our administrative proceedings.89 The legislative history that Respondents cite does not undermine the analysis of the D.C. Circuit. We accordingly reject Respondents' challenges to the manner of appointment of our ALJs.90
81 Respondents filed a Motion to Submit Supplemental Briefing regarding their Appointments Clause claims. The motion does not contain the required certificate of compliance and exceeds the length limitation specified in Rule of Practice 154(c). 17 C.F.R. § 201.154(c). The Motion is stricken pursuant to Rule of Practice 180(b). Id. § 201.180(b). Nevertheless, and in the alternative, we have considered and rejected the arguments contained therein.Pages 26 -27 of the SEC Opinion
82 See, e.g., Timbervest, 2015 WL 5472520, at *23-25; Lucia, 2015 WL 5172953, at *21- 23. In a footnote, Respondents also assert that the manner of removing ALJs is unconstitutional in light of the Supreme Court's decision in Free Enterprise Fund v. PCAOB. We have also rejected this argument. See, e.g., Timbervest, 2015 WL 5472520, at *26-28.
83 204 F.3d 1125 (D.C. Cir. 2000) (holding that, for purposes of the Appointments Clause, ALJs at the Federal Deposit Insurance Corporation ("FDIC"), who oversee the FDIC's contested administrative proceedings, are employees rather than inferior officers).
84 832 F.3d 277, 280 (D.C. Cir. 2016).
85 Id. at 288.
86 Id. at 289.
87 See, e.g., 15 U.S.C. §§ 77s(c), 77u.
88 Lucia, 832 F.3d at 289.
89 We have also noted "that the Administrative Procedure Act "consistently uses the term 'officer' or the term 'officer, employee, or agent' to 'refer to [agency] staff members.'" Timbervest, 2015 WL 5472520, at *26 n.165 (quoting Kenneth Culp Davis, Separation of Functions in Administrative Agencies, 61 HARV. L. REV. 612, 615 & n.11 (1948)); cf. 5 U.S.C. §§ 556-57 (referring to official who presides over hearing as the "presiding employee"). Moreover, the Dictionary Act provides an interpretive presumption that the term "'officer' includes any person authorized by law to perform the duties of the office." 1 U.S.C. § 1.
90 On December 27, 2016, the Tenth Circuit held that "SEC ALJs are inferior officers under the Appointments Clause." SEC v. Bandimere, __ F.3d __, 2016 WL 7439007, at *7 (10th Cir. Dec. 27, 2016). The government is considering options for further review. In this case, the record indicates that Respondents may appeal to the D.C. Circuit but not to the Tenth Circuit. See 15 U.S.C. 78y(a). Accordingly, we adhere to the D.C. Circuit's decision in Lucia. See Indep. Petroleum Ass'n v. Babbitt, 92 F.3d 1248, 1261 (D.C. Cir. 1996) (acknowledging the permissibility of "intercircuit nonacquiescence . . . , especially when the law is unsettled"); Samuel Estreicher and Richard Revesz, Nonacquiescence by Federal Administrative Agencies, 98 YALE L.J. 679, 687, 735 (1989) (stating that an agency engages in "intercircuit nonacquiescence" by declining to follow "the case law of a court of appeals other than the one that will review the agency's decision" and that "an agency's ability to engage in intercircuit nonacquiescence should not be constrained").
"Commissioner Piwowar Challenges SEC To Be Fair And Effective" (BrokeAndBroker.com Blog, October 17, 2014).On October 14, 2014, Commissioner Piwowar addressed the Securities Enforcement Forum. Commissioner Piwowar has a Ph.D in Finance, which provides him with a different perspective than most of his predecessors and colleagues. Towards the beginning of his speech, he tackles the issue of due process and, thereafter, points a finger at the SEC's enforcement protocol:For me, due process starts with fundamental notions of fairness. Persons should be on notice as to what acts, or failures to act, constitute violations of the law and our regulations. Persons should also be on notice as to the potential sanctions and liabilities that may be imposed as a result of those violations.. . .Additionally, I oppose the use by the Commission of enforcement measures as an alternative to rulemaking under the Administrative Procedure Act.The Administrative Procedure Act, with its requirements for the government to engage in notice and comment rulemaking, implements key due process protections. I understand the frustrations of the rulemaking process. It takes a significant amount of time, effort, and bandwidth for the Commission to propose and adopt rules under the Administrative Procedure Act. Nevertheless, I have significant concerns when Commission orders - especially in settled administrative actions - create new interpretations of the laws or regulations or impose new regulatory requirements. When Commission actions create such results, we fail in our duty to uphold due process.
Bill Singer's Comment: Bravo! Commissioner Piwowar perfectly enunciates the need for fair notice about what conduct may constitute a violation and the consequences of such misconduct. For too long, Wall Street's regulators have codified regulations through prosecution and enforcement, which tended to come off a make-it-up-as-you-go-along undertaking. Notwithstanding the explosion of laws, rules, and regulations, the "interpretation" and the even-handed application of those proscriptions don't also seem a priority. The result is a lot of wasted regulation because many apparent successful prosecutions and enforcement actions are ultimately over-turned on appeal.
On December 27, 2016, the Tenth Circuit held that "SEC ALJs are inferior officers under the Appointments Clause." SEC v. Bandimere, __ F.3d __, 2016 WL 7439007, at *7 (10th Cir. Dec. 27, 2016). The government is considering options for further review . . ."