Banking and Finance Law Daily SEC’s law judges are inferior officers, says Supreme Court
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Thursday, June 21, 2018

SEC’s law judges are inferior officers, says Supreme Court

By Mark S. Nelson, J.D.

The Supreme Court held that the SEC’s administrative law judges are inferior officers of the U.S. government for purposes of the U.S. Constitution’s Appointments Clause. The court’s opinion largely compares the SEC’s ALJs to the Tax Court’s special trial judges (STJs) whom the court previously held were officers in its Freytag opinion, an opinion that had factored prominently in the D.C. Circuit’s decision in Lucia that the SEC’s ALJs were employees instead of officers. The Supreme Court’s decision is consistent with the Tenth Circuit’s Bandimere opinion, which likewise held the SEC’s ALJs are officers. The upshot of the opinion is that Raymond Lucia is entitled to a new hearing before a different ALJ or before the Commission itself (Lucia v. SEC, June 21, 2018, Kagan, E.).

Six justices formed the core majority with a seventh justice, Justice Breyer, concurring in the judgment to the extent that the ALJ in Lucia’s case was not properly appointed, but otherwise dissenting. Justice Sotomayor issued a dissent joined by Justice Ginsburg. Justices Thomas and Gorsuch, in a concurrence, urged a more expansive outcome based on principles of originalism. Overall, the court’s opinion is a narrow one that leaves unanswered the removal question urged by the government but not explicitly made part of the court’s certiorari grant.

Lucia frames constitutional question. The question of whether the SEC’s ALJs are inferior officers of the U.S. or employees beyond the reach of the Appointments Clause arises because of the Constitution’s language allowing certain federal officials to appoint inferior officers. Article II, §2, cl. 2 provides that "the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments." The majority affirmed that the Commission, a multimember entity, falls within the meaning of "Heads of Departments." Because the ALJ in Lucia’s case was appointed by SEC staff, not the Commission, Lucia had argued before the Commission and then in the federal court that he was subjected to an in-house process overseen by an ALJ who was not constitutionally appointed.

The SEC charged that Lucia and his eponymous company violated the Advisers Act in pitching Lucia's "Buckets of Money" investment strategy, especially with respect to back test data suggesting the results investors could expect. The Commission upheld the ALJ’s initial decision and imposed civil money penalties of $250,000 on Raymond J. Lucia Companies, Inc. and $50,000 on Lucia himself. The adviser registrations for both Lucia and his company were revoked, and Lucia was subjected to a lifetime bar from associating with any advisers or broker-dealers. The Commission also rejected Lucia's assertion that the SEC's ALJ in his case was not constitutionally appointed. A dissent to the Commission's decision filed by then-Commissioner Daniel Gallagher and Commissioner Michael Piwowar disputed the majority's findings regarding back tests and suggested that Article III courts should decide the constitutional question Lucia raised even though the Commission can express an opinion on that question.

The D.C. Circuit upheld the Commission’s findings regarding Lucia, but the full court later agreed to rehear the case, but with a twist because the PHH case involving the Consumer Financial Protection Bureau would be heard the same day and raised, in part, similar issues. In doing so, the court asked the parties to explain whether the D.C. Circuit’s Landry decision should be overruled. Landry was the case where a majority held that the FDIC’s ALJs were not inferior officers, although Judge Randolph concurred in order to note the alternative holdings in the Supreme Court’s Freytag opinion, which Judge Randolph said could support a finding that the FDIC’s ALJs were officers of the U.S. Lucia’s petition for review was eventually denied by an equally divided en banc D.C. Circuit. The Supreme Court did not cite Landry in its opinion in Lucia.

Officer status—Freytag is controlling precedent. Justice Kagan, writing for the majority, posited two foundational requirements for a federal government employee to be an inferior officer for purposes of the Appointments Clause: (1) the person must hold a continuing job created by law; and (2) the person must exercise significant authority. Although the government and the court-appointed amicus defending the judgment below urged the court to provide more guidance on when a person becomes an inferior officer, the majority declined to respond because its Freytag opinion, in which it held that the Tax Court’s STJs were officers, resolves Lucia’s case (Justice Sotomayor’s dissent and Justice Thomas’s concurrence asked for more guidance on what constitutes significant authority; Justice Thomas further noted that Freytag may not control in every similar case in the future). Justice Kagan did note the amorphous nature of the significant authority prong: "The standard is no doubt framed in general terms, tempting advocates to add whatever glosses best suit their arguments." The court referred to the SEC’s ALJs and the Tax Court’s STJs as "near-carbon copies."

In Freytag, Tax Court STJs’ decisions were final in some lesser matters, while their proposed decisions in major matters were always subject to review by a Tax Court judge. The court in Freytag had elaborated on its findings by offering alternative holdings: (1) STJs exercise significant authority even in matters where they are not final; and (2) STJs were final in some matters, and it would make little sense to hold they are officers for some, but not all, purposes under the Appointments Clause.

According to the majority, Lucia was an easy case because the SEC’s ALJs potentially have greater autonomy than the STJs at issue in Freytag. Like Freytag, the SEC’s ALJ in Lucia’s case undisputedly held a continuing job under U.S. law. Likewise, the majority said, the SEC’s ALJ exercised significant discretion over four things akin to the powers of the STJs: (1) the taking of testimony; (2) conducting trials; (3) ruling on the admissibility of evidence; and (4) enforcing compliance with discovery orders, for example, by punishing contempt by excluding persons from hearings. Moreover, in Lucia, the court said the Commission can decline to review an ALJ’s initial decision and, thus, in those circumstances, the ALJ’s decision is final.

Justice Kagan foreshadowed the majority’s comparison of Lucia to Freytag during oral argument (transcript). In an exchange with Anton Metlitsky, the court-appointed amicus, Justice Kagan focused on the parallels between Freytag and Lucia. Said Justice Kagan:

I guess what strikes me [interruption by amicus] Mr. Metlitsky, is that if you had a list and you said top 10 attributes of the judges that were involved in Freytag and the judges that are involved here, you'd pretty much say that nine of them are the same and maybe one is different.

And—but it's just so hard to get around this—the commonalities of these judges and the judges in Freytag.

As for the remedy, Lucia will get a new hearing by either an ALJ other than ALJ Cameron Elliott, who heard the matter initially, or by the Commission itself. Justice Kagan explained that an Appointments Clause violation requires a new hearing by a properly appointed ALJ but that the court was adding a requirement that the new hearing be before a different ALJ because ALJ Elliott would be unable to decide the matter with a fresh mind after having decided it previously. Justice Breyer’s concurring and dissenting opinion disputed this form of remedy.

Narrow opinion. Justice Kagan had argued the Free Enterprise case involving the Public Company Accounting Oversight Board (PCAOB) as Solicitor General, but it was not until Lucia that her views on the similar, although not necessarily identical, issues began to emerge. In writing for the majority in Lucia, Justice Kagan has crafted a relatively narrow decision limited to the Appointments Clause issue.

In his Free Enterprise dissent, Justice Breyer had listed the "horribles" that may result from a finding that ALJs are officers, a point he renewed at oral argument in Lucia. Also at oral argument, Justice Kennedy had asked about ALJs at other federal agencies, including the Social Security Administration (SSA), which Justice Breyer’s Free Enterprise dissent noted had the most ALJs of any federal agency. Lucia’s counsel, Mark Perry, replied that only 150 ALJs would be impacted by a decision in Lucia’s case because they decide adversarial proceedings as defined by the Administrative Procedure Act and that the SSA’s ALJs would not be impacted.

At oral argument, Justice Gorsuch raised the question of what effect the Commission’s order ratifying the appointment of its ALJs in pending cases had on Lucia’s case. In a footnote, the majority noted that Lucia had argued the order was invalid, but the court declined to address the question. But the court did observe in a footnote that a new ALJ would have to be constitutionally appointed independent of the SEC’s ratification order.

Lastly, when the government confessed error in Lucia’s case, it had asked the justices to add a question dealing with the removal issue, arguing that the SEC’s ALJs may enjoy too many layers of tenure protection, something potentially barred by Free Enterprise. The court’s certiorari grant did not address this question, and the court again in its opinion declined to address the question of whether statutory limits on the removal of the SEC’s ALJs are constitutional. The government in Lucia also noted that other cases are pending in the courts of appeal that do raise the separation of powers question and the removal issue. Counsel for Lucia told the court in a reply brief that Lucia could raise the removal issue if he were once again charged by the SEC and subjected to a proceeding before a constitutionally appointed ALJ.

Breyer’s critique. Justice Breyer concurred in the judgment in part and dissented in part, while reviving some of the points he made in his dissent in the Free Enterprise case involving the PCAOB. Although Justice Breyer agreed that the Commission did not properly appoint the ALJ who heard Lucia’s case, he disagreed that the remedy should be new hearing before a different ALJ (emphasis added). Justice Breyer said the Commission has now ratified the ALJ that heard Lucia’s case and, much as would happen when a new trial is ordered in a federal court case, the original ALJ, like the original trial judge, should hear the case. Moreover, Justice Breyer said that this question was not briefed and that the appeals court should have a chance to address it first.

Justice Breyer also disputed the legal basis for the majority’s decision. Justice Breyer would have relied on the Administrative Procedure Act, which he said denies agencies the ability to delegate ALJ appointments to staff, as an alternative to deciding the case on constitutional grounds.

For Justice Breyer, moreover, the majority’s piece-meal approach to the Appointments Clause and removal questions also could put the federal government’s civil service at risk in a future case. "By considering each question in isolation, the Court risks (should the Court later extend Free Enterprise Fund) unraveling, step-by-step, the foundations of the Federal Government’s administrative adjudication system as it has existed for decades, and perhaps of the merit-based civil-service system in general," said Justice Breyer.

The dissent. Justice Sotomayor, joined by Justice Ginsburg, offered the most comprehensive dissent in reply to the majority’s use of Freytag, while also joining Justice Breyer regarding the remedy selected by the majority. Justice Sotomayor acknowledged that the Commission’s ALJs have "extensive powers," but she asserted that the majority placed too much emphasis on a part of Freytag that was unnecessary to the decision in that case. Instead, Justice Sotomayor said Freytag is "consistent" with requiring a person to have finality in order to be an inferior officer. Justice Sotomayor further said in a footnote that the majority in Lucia’s case was "not inconsistent" with this understanding, even if the majority erroneously found that the initial decisions of SEC ALJs sometimes can be final. Justice Sotomayor noted SEC Commissioner Robert Jackson’s blog post about the nature of ALJ decisions at the SEC. But Justice Kagan’s majority opinion, in footnote 4, observed that Freytag had "two parts," such that the dissent’s theory of finality is inconsistent with Freytag.

Lack of guidance, originalism, and finality. Justices Sotomayor and Thomas reached different conclusions in Lucia, but they appear to agree on the lack of guidance contained in the court’s precedents. The justices, however, renewed their disagreements over what direction the court should take to provide more clarity about the dividing line between inferior officers and employees.

According to Justices Thomas and Gorsuch, who teamed up for a concurrence, the answer lies in the "original meaning" the founders ascribed to the definition of "officer" (the concurrence noted that it focused on the differences between inferior officers and employees, but did not address "officer" in other contexts). Said Justice Thomas: "I would resolve that question based on the original public meaning of ‘Officers of the United States.’ To the Founders, this term encompassed all federal civil officials ‘with responsibility for an ongoing statutory duty.’"

For Justice Thomas, the lack of clarity in the Supreme Court’s prior cases arises from the murky distinctions between what is "sufficient" for one to be an officer and what is "necessary" for that person to be an officer. While Justice Thomas agreed that the majority correctly applied Freytag to Lucia’s case, he also said that, for him, the relevant test is whether an ALJ continuously performs a job of significance and not the "importance or significance" of the ALJ’s statutory duties.

By contrast, Justice Sotomayor said the majority’s twin touchstones for inferior-officer status, holding a continuous office and exercising significant authority, offer little guidance, especially the significance prong. According to the justice:

To provide guidance to Congress and the Executive Branch, I would hold that one requisite component of "significant authority" is the ability to make final, binding decisions on behalf of the Government. Accordingly, a person who merely advises and provides recommendations to an officer would not herself qualify as an officer.

Road to the Supreme Court. Although the SEC’s ALJs’ decisions have been periodically challenged on due process and equal protection grounds, the concerted attempt to subject the agency’s ALJs’ work to constitutional precepts began in earnest a few years ago. The bulk of these cases alleged violations of the Appointments Clause and/or separation of powers and were brought in federal courts with an eye to halting in-house proceedings. The Dodd-Frank Act’s expansion of the SEC’s authority to bring in-house actions against certain respondents also was a factor in prompting constitutional challenges to the agency’s ALJs.

The early challenges raised primarily jurisdictional questions for the federal district courts. At times, the district courts issued injunctions stopping SEC administrative cases, but many district courts declined to stop SEC proceedings. Judge Leigh Martin May of the Northern District of Georgia was one of the judges to enjoin an SEC administrative proceeding while suggesting what the SEC and at least one other agency would eventually do: ratify the actions of their ALJs. All federal appellate courts to address the jurisdictional questions raised by SEC respondents eventually ruled in favor of the SEC. The main reason for not stopping the administrative proceedings was that Congress created a statutory scheme in the Exchange Act through which administrative matters must be channeled absent extreme facts, such as that the respondent would have to "bet the farm" in order to have a chance to challenge the constitutionality of the SEC’s ALJs. In other words, SEC respondents could file a petition for review in a federal appeals court regarding an adverse decision of an SEC ALJ that was then upheld by the Commission.

Two other reasons worked against SEC respondents who asked district courts to stop their in-house proceedings. One was the Supreme Court’s precedent that the cost of defending oneself against civil or criminal charges is part of the price one pays for living in a democracy governed by the rule of law. Another was that in-house matters sometimes are decided in a respondent’s favor. A prime example is an ALJ’s decision to dismiss as unproven charges that Lynn Tilton and her firm Patriarch Partners, LLC ran afoul of the Investment Advisers Act’s antifraud provisions as a result of disclosure issues and accounting irregularities regarding collateralized loan obligations. Titlon had also brought a legal challenge to the SEC’s ALJs in federal district court.

The Supreme Court denied certiorari in the jurisdictional cases that reached the court, and the focus then shifted to whether an SEC respondent could persuade the court to take up a petition for review asserting Appointments Clause violations. The Lucia case, however, was not the first of these cases to reach the Supreme Court. Gordon Brent Pierce tried unsuccessfully to get the Supreme Court to review constitutional issues he raised late in the federal appeals process. But Lucia would eventually provide a somewhat better vehicle for the Supreme Court versus the Tenth Circuit’s Bandimere case, which had raised the question of whether Justice Gorsuch had participated in the denial of rehearing while he was still on the Tenth Circuit. The grant in Lucia came after the Trump Administration’s Solicitor General confessed error after having said in Bandimere that it would provide a fulsome reply in Lucia instead. Previously, the government had defended the SEC’s ALJs.

If the Supreme Court had not taken the Lucia case, the justices likely would have taken one of the several similar cases being held in abeyance by federal appeals courts pending the decision in Lucia. A Fifth Circuit case directly confronting the D.C. Circuit’s Landry decision in the FDIC context already has suggested that an FDIC ALJ was unconstitutionally appointed.

The case is No. 17-130.

Attorneys: Mark A. Perry (Gibson Dunn & Crutcher LLP) for Raymond J. Lucia and Raymond J. Lucia Companies, Inc. Noel J. Francisco, Solicitor General, for the U.S. Anton Metlitsky (O'Melveny & Myers LLP), court-appointed amicus curiae defending the judgment below.

Companies: Raymond J. Lucia Companies, Inc.

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