BREAKING NEWS: 2nd Circuit Delivers Blow to Tilton Appeal

June 2, 2016

On June 1, 2016, the United States Court of Appeals for the Second Circuit ("2Cir") announced its decision on the appeal by Plaintiffs in the high-profile Tilton v. SEC, which has been covered extensively in the press of over a year.  In light of the prior coverage, the Blog's commentary today will be relatively short and to the point, and readers will be directed via links to key online documents.


We start with a March 30, 2015, Securities and Exchange Commission ("SEC") Order Instituting Proceedings and Notice of Hearing ("OIP"), which alleges in its "Summary" preamble:

1. Since 2003, Respondents have defrauded three Collateralized Loan Obligation ("CLO") funds they manage and these funds' investors by providing false and misleading information, and engaging in a deceptive scheme, practice and course of business, relating to the values they reported for these funds' assets. Lynn Tilton, who controls and makes relevant decisions on behalf of each of the Respondents, is responsible for all of these violations.
2. The three CLO funds, collectively known as the "Zohar Funds," raised more than $2.5 billion from investors and used these investments to make loans to distressed companies. These loans to distressed companies are the primary assets of the Zohar Funds. However, many of the distressed companies have performed poorly and have not made interest payments, or have made only partial payments, to the Funds over several years.
3. As required under the relevant deal documents, through the trustee, Tilton's entities regularly provide information to the Funds and their investors about the performance of the Funds. This information includes valuation categorizations of the Funds' assets and financial statements purportedly reflecting the financial position of each Fund.
4. Despite the poor performance of many of the Funds' assets, Tilton has intentionally and consistently directed that nearly all valuations of these assets be reported as unchanged from their valuations at the time the assets were originated.
5. These actions are inconsistent with the categorization methodology set forth in documents governing the Funds. This methodology turns on, among other factors, whether a distressed company has timely made interest payments to the Funds. Instead of applying this methodology, Tilton instead substitutes her own, independent discretion when categorizing the Funds' investments. At Tilton's direction, Respondents will not assign a lower valuation category to an asset unless and until Tilton subjectively decides to stop "supporting" the distressed company.
6. If Respondents had applied the categorization methodology set forth in the documents, certain valuation ratio tests derived from the categorizations would have failed by at least 2009. As a result, based on other provisions in the documents, management fees and other payments to Tilton and her entities would have been reduced by almost $200 million, and investors would have gained more control over the Funds' activities, among other consequences. By applying her own discretion rather than the valuation methodology set forth in the governing documents, Tilton has avoided these consequences and taken 3 excessive fees from the Funds. As a result, Respondents' practices were inconsistent with disclosures and created a clear conflict of interest.
7. Respondents also prepare quarterly financial statements for the Funds, which are provided to investors. These financial statements include disclosures about the Funds' loan impairment policy and portfolio fair value. Tilton certifies these financial statements and represents that they are prepared in conformity with generally accepted accounting principles ("GAAP").
8. However, contrary to these statements, Respondents do not prepare the financial statements in conformity with GAAP. Significantly, rather than applying a GAAP-compliant impairment methodology, Respondents impair assets only when Tilton decides to withdraw support for a distressed company. This approach mirrors the discretionary approach Tilton uses to categorize assets and does not conform with GAAP. It is also inconsistent with other disclosures in the financial statements that falsely indicate that Respondents assess and consider impairment issues and the fair value of the Funds' loan assets.
9. Respondents have never disclosed Tilton's discretionary valuation approaches to the Funds or their investors, much less the conflict of interest these approaches created. As a result, Respondents also breached their fiduciary duties and their contractual standard for managing the Zohar Funds as set forth in the relevant deal documents.

In the Matter of Lynn Tilton; Patriarch Partners, LLC, Patriarch Partners VIII, LL;; Patriarch Partners XIV; LLC; And Patriarch Partners XV; LLC, Respondents (OIP, Invest. Adv. Act 4053; Invest Co. Act 31539; Acct and Auditing Enf. Rel. 3644; and Admin. Proc. File 3-16462 / March 30, 2015)


The Respondents in the above SEC matter  brought an action in the United States District Court for the Southern District of New York ("SDNY") asserting that the SEC's scheme for appointing and removing its Administrative Law Judges ("ALJs") violated the "Appointments Clause" of the United States Constitution; and, as a consequence of that alleged constitutional infirmity, Respondents (Plaintiffs in the SDNY lawsuit) argue that any presiding hearing officer would lack lawful authority.  Accordingly, the Plaintiffs moved SDNY to issue a preliminary injunction barring the SEC from proceeding against them. 

On June 30, 2015, SDNY Judge Abrams denied the motion for preliminary injunction and as set forth in the "Conclusion" section of her Opinion and Order:

Plaintiffs contend that it is unconstitutional-and unfair-for the Commission to subject them to an enforcement action before the Commission's own Administrative Law Judge. But that question is not for this Court to decide. Congress has carefully delineated the distinct roles of the Commission and the courts in cases such as this. It rests first with the Commission to determine whether to commence an action at all, and if so, whether to do so in federal district court or in its own administrative tribunal. Having chosen the latter, it rests with an ALJ and then the Commission to rule on Plaintiffs' claims. That decision in tum is subject to appeal to a federal court of appeals. In this Court's view, there is no basis to allow Plaintiffs to bypass this congressionally created remedial scheme. Accordingly, this Court lacks subject matter jurisdiction over this action.


Having lost at SDNY, the Plaintiffs appealed to the United States Court of Appeals for the Second Circuit ("2Cir"), which on June 1, 2016, affirmed SDNY with Judges Sack and Newman concurring but Judge Droney dissenting. As set forth in the "Conclusion" portion of the 2Cir Opinion:

After considering each of the Thunder Basin factors, we conclude that Congress intended the appellants Appointments Clause claim to be reviewed within the SEC's exclusive statutory structure. Free Enterprise, 561 U.S. at 489 (quoting Thunder Basin, 510 U.S. at 207) The threshold nature of the claim does not defeat the presumption that it, like other procedural and substantive defenses to an enforcement action, must be resolved in the first instance through agency proceedings. To the contrary: "Many respondents in SEC proceedings join substantive defenses to their securities charges together with challenges to the Commission's actions or authority. It makes good sense to consolidate all of each respondent's issues before one court for review, and only after an adverse Commission order makes that review necessary. Jarkesy, 803 F.3d at 29 -30.We therefore conclude, in keeping with the decisions of the Seventh and D.C. Circuits in Bebo and Jarkesy, that the appellants must await a final Commission order before raising their Appointments Clause claim in federal court. The judgment of the district court is AFFIRMED, and our stay on further proceedings by the SEC is VACATED.

Lynn Tilton; Patriarch Partners, LLC, Patriarch Partners VIII, LL;; Patriarch Partners XIV; LLC; And Patriarch Partners XV; LLC, Plaintiffs-Appellants,, v. Securities and Exchange Commission, Defendant-Appellee (Opinion, 2Cir, 15-2103 / June 1, 2016)  

In his Dissent, Judge Droney asserts that he would reverse the SDNY and remand for an adjudication of the Appointments Clause claim. In noting his disagreements, Judge Droney explains, in part:

In sum, to agree with the majority's interpretation of Elgin, one must conclude that the Supreme Court intended to eliminate any substantive analysis of the "wholly collateral" and the "outside the agency's expertise" factors in any case where an administrative proceeding is ongoing. To the contrary, Elgin itself engages with the substance of the precluded claims in a way that the majority seems to believe is now unnecessary. . .
. . .

I see no difference between the Appointments Clause challenge in Free Enterprise and here; it is completely collateral to the work of the PCAOB as well as to the work of the SEC and its ALJs.I would find that this factor weighs strongly in favor of jurisdiction

Bill Singer's Comment

As Judge Droney aptly raises, the Supreme Court has previously ruled on similar circumstances to those in Tilton, and the Court disapproved, in part, of the PCAOB's appointment of certain of its officers. In Free Enterprise Fund et al. v. Public Company Accounting Oversight Board et al. (Opinion, S.Ct. June 28, 2010), the Supreme Court considered whether the President of the United States may 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. As held in the Supreme Court's PCAOB Opinion:

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.

Page 2 of the Opinion

The Constitution that makes the President accountable to the people for executing the laws also gives him the power to do so. That power includes, as a general matter, the authority to remove those who assist him in carrying out his duties. Without such power, the President could not be held fully accountable for discharging his own responsibilities; the buck would stop somewhere else. Such diffusion of authority "would greatly diminish the intended and necessary responsibility of the chief magistrate himself." The Federalist No. 70, at 478.

While we have sustained in certain cases limits on the President's removal power, the Act before us imposes a new type of restriction-two levels of protection from removal for those who nonetheless exercise significant executive power. Congress cannot limit the President's authority in this way.

Page 33 of the Opinion

As made clear by the 2:1 majority nature of the 2Cir's Opinion, there is still an open issue as to whether the Appointments Clause renders certain of the SEC's ALJs as lacking lawful authority.  If the Tilton Plaintiffs appeal to the Supreme Court and if that institution grants cert, we may yet witness another epic battle over how certain federal positions are filled and whether the manner of hiring/firing is unconstitutional and, as such, renders those appointed as "unlawful" officers.