The Security and Exchange Commission (SEC) is treading on thin legal ground, according to Manhattan District Judge Richard Berman, due to the agency’s use of an in-house judicial system. On Monday, Berman refused to dismiss a lawsuit filed by embattled former Standard and Poor’s (S&P) supervisor, Barbara Duka, who was accused of securities fraud by the SEC in November. Duka headed the mortgage ratings division for S&P, grading new mortgage investments and overseeing existing mortgage ratings. The SEC is questioning her behavior and communication with her subordinates in a 2011 decision to pull the preliminary rating on a $1.5 billion security that was ultimately restructured before coming to market. The decision upset both investors and the security’s issuer. Duka denies any wrongdoing, with her attorney Guy Petrillo saying, “Barbara did not act wrongfully and always performed her duties at S&P in the utmost good faith. Anyone who would claim otherwise should be required to prove their claim in court and in public, as our Constitution requires.”
The problem for Duka and her attorney, as well as other officials under investigation by the SEC is the agency’s administrative law procedures. Empowered by increased authority given to the agency from the 2010 Frank-Dodd financial reform legislation, the SEC has often avoided federal court, and instead has increasingly relied on its in-house administrative judicial system. Duka is scheduled to appear before an SEC in-house judge on September 16th to face civil charges of fraud; however she sued in January to move the case to federal court so she could present her case in a public venue as opposed to within the regulator’s home confines. The SEC administrative law system’s constitutionality has been put into serious question after a ruling two months ago by Atlanta U.S. District Judge Leigh Martin May, who ruled to temporarily suspend the insider trading case against investor Charles Hill, calling the 5-judge administrative panel “likely unconstitutional.” Judge May ruled that the judges were “officials,” and should therefore be appointed by the SEC’s commissioners and not by the lower-level executives who appointed them.
While Judge Berman did not go as far as issuing a court order declaring the SEC’s administrative law procedures to be unconstitutional on Monday, which Duka was seeking to accomplish, he gave the agency seven days to show “its intention to cure any violation” of the Constitution. Berman said that the issue could be easily solved if the SEC took May’s advice and allowed the commissioners to appoint the judges instead of managers. The SEC believes that doing so, however, will unravel many of the previous rulings in prior cases that the administrative court has conducted, subjecting the agency to myriad legal challenges. The SEC is also worried that any revamping of its administrative law structure will affect similar systems in other federal departments. The in-house procedures are designed to fast-track cases of financial wrongdoing; however Duka’s attorneys argue that it is not fair to rush a complicated case like Duka’s and several others which often require much nuance and technical understanding. There are over 830,000 documents in the SEC’s investigative file in the Duka case. Federal courts allow for more time and thoroughness, says her attorney.
The agency has faced enormous challenges in the wake of the 2008 financial meltdown and the Dodd-Frank legislation has led to a major vacuum of legal standing. According to a May interview with CNBC’s Bob Pisani, SEC Commissioner Dan Gallagher said he was frustrated by the “distraction” of the Dodd-Frank financial reforms, saying “This is my fourth year as commissioner, I’ve been on the staff before, and I can tell you in the past four years we are somewhere between 10 and 20 times the number of normal rule writing capacity.” If the SEC is unable to find constitutional backing for its administrative law system, the agency’s burden will likely increase even more. Administrative law expert and Assistant Professor at the University of Georgia’s Law School, Kent Barnett said, “The SEC’s handling of this whole issue around administrative-law judges shows how it caught them flat-footed.” Gallagher however, has defended the agency’s actions under the circumstances, saying about the provisions in Dodd-Frank, “Some of them are just completely nonsensical. I mean, nothing to do with the financial crisis, aren’t really germane to the function of the SEC and that’s what happens when you get a runaway piece of legislation.” It is likely that additional federal challenges to what the SEC can and cannot enforce will persist in light of the sweeping Dodd-Frank reform, for better and worse.
JD Supra – Thomas Potter III
Reuters – Nate Raymond
Wall Street Journal – Jean Eaglesham