Appeals Court Decision Creates Circuit Split on the Constitutionality of the SEC Administrative Law Process

January 2017

The 10th Circuit Court of Appeals closed out 2016 with a bang when it ruled that the SEC’s use of administrative law judges violates the Constitution. In Bandimere v. SEC,[1] the Court held in a 2-1 decision that SEC Administrative Law Judges (“ALJs”) are “inferior officers” who hold their positions in violation of the Appointments Clause.[2] This ruling creates a split of authority among the Circuits that will likely lead to a review by the Supreme Court.

Until then, defendants in SEC administrative law proceedings should object to the administrative proceeding process as being unconstitutional, and thus preserve their rights. Raising the argument and preserving it during an administrative law proceeding could mean the difference between being stuck with an adverse ALJ decision and being able to challenge the constitutionality of the SEC’s administrative law process in federal court after a final determination is made in the SEC’s administrative law proceeding.

Background
Bandimere reached the 10th Circuit by way of petition after an SEC ALJ found (and the Commission affirmed on review) that David Bandimere, a Colorado businessman, was liable for violating securities laws. The Commission issued an opinion barring him from the securities industry, imposing civil penalties and ordering disgorgement. During the proceedings, the Commission not only found Bandimere’s defenses to the allegations unpersuasive, it also rejected Bandimere’s constitutional argument that the SEC’s ALJs hold their positions in violation of the Appointments Clause.[3]

Other respondents in similar circumstances had attempted to challenge the constitutionality of the SEC’s administrative law process by filing collateral lawsuits in federal court. These collateral lawsuits often failed for lack of jurisdiction because federal courts were precluded from entertaining arguments that had not been raised and exhausted in administrative proceedings. Instead of filing a collateral suit, however, Bandimere wisely raised the constitutional argument during the administrative proceedings. Once the Commission reviewed the decision of the SEC ALJ and made a final determination, Bandimere was able to present his argument on appeal to the 10th Circuit.[4]

In Bandimere, the 10th Circuit set aside the Commission’s opinion and found the SEC’s ALJ appointment process to be unconstitutional. The Court’s decision hinged on the status of SEC ALJs and the distinction between “inferior officers” and “employees” -- the latter being exempt from the Appointments Clause. In this case, the SEC conceded that its ALJs were not constitutionally appointed, and relied on the argument that its ALJs were “employees” who need not be appointed by the President, a court of law or a department head. However, the 10th Circuit disagreed and held that SEC ALJs are in fact “inferior officers.”[5] This ruling marks a clear departure from the 2016 decision in Raymond J. Lucia Cos., Inc. v. SEC,[6] in which the D.C. Circuit Court of Appeals unanimously held that SEC ALJs are “employees” for purposes of the Appointments Clause.

A Bona Fide Circuit Split
The rift between the 10th Circuit and D.C. Circuit rulings boils down to the Courts’ different interpretations of the criteria used for determining the status of ALJs. As the 10th Circuit majority explained, “the Supreme Court has not stated a specific test for inferior officer status.”[7] In Bandimere, the Court relied on Freytag v. Comm’r of Internal Revenue,[8] an analogous case in which the Supreme Court found that the Tax Court’s Special Trial Judges (“STJs”) were “inferior officers” for purposes of the Appointments Clause.  

In Freytag, the Supreme Court used a three-part test to determine the status of the STJs. This test focused on whether: (1) the STJ position was “established by law” in the Administrative Procedure Act (the “APA”); (2) statutes set out the duties, salaries and hiring process for the STJs; and (3) STJs “exercise significant discretion” in “carrying out … important functions.”[9] Using the same test, the Bandimere majority concluded that SEC ALJs, like the Tax Court’s STJs in Freytag, meet the criteria for “inferior officer” status. First, the SEC ALJ position was established by the APA. Second, the 10th Circuit found various statutes that set forth the SEC ALJs’ duties, salaries and hiring process. Third, and perhaps most important to its analysis, the Court found that SEC ALJs “exercise significant discretion” in “carrying out important functions.”[10] Regarding this third requirement, the Court took note of a long list of SEC ALJ duties, which include, inter alia, shaping the administrative record by taking testimony, regulating document production and depositions, ruling on the admissibility of evidence, ruling on procedural and dispositive motions, issuing subpoenas, determining liability and imposing sanctions.[11]

Having found that SEC ALJs meet all three Freytag requirements, the 2-1 majority held that SEC ALJs are “inferior officers” who hold their positions in violation of the Appointments Clause.[12] As mentioned earlier, this decision is in direct conflict with the D.C. Circuit’s decision in Lucia, which had been issued only a few months prior.

In Lucia, which also included a discussion of the Freytag three-part test, the D.C. Circuit took a different approach in determining whether SEC ALJs exercise “significant discretion” in “carrying out important functions.”[13] The Court indicated that once an appointee meets the first two threshold requirements (that the position is established by law and the position’s duties, salary and means of appointment are set forth in a statute), then “‘the main criteria for drawing the line between inferior officers and employees … are (1) the significance of the matters resolved by the officials, (2) the discretion they exercise in reaching their decisions, and (3) the finality of those decisions.’”[14] Here, the D.C. Circuit relied heavily on its decision in Landry v. FDIC,[15] where the Court held that Federal Deposit Insurance Corporation (“FDIC”) ALJs were “employees” and not “inferior officers” because they lacked final decision-making power.[16] In Lucia, the D.C. Circuit found that because SEC ALJ decisions are subject to review by the Commission, SEC ALJs, like FDIC ALJs, do not have final decision-making power. Therefore, the Court concluded, SEC ALJs are “employees” for purposes of the Appointments Clause.[17]

Essentially, the difference between the D.C. Circuit and 10th Circuit rulings is that the D.C. Circuit found the issue of final decision-making authority to be dispositive, whereas the 10th Circuit found that the overall duties of SEC ALJs are both extensive and important enough to confer “inferior officer” status. Although the 10th Circuit did not find the issue of final decision-making authority to be dispositive, the Court noted that about ninety percent of SEC ALJ decisions become final without any review by an SEC Commissioner[18] -- suggesting that SEC ALJs have de facto final decision-making authority.

Where Do We Go from Here?
The D.C. Circuit is currently considering whether to grant a rehearing en banc in Lucia, and the 10th Circuit’s ruling in Bandimere is also likely to lead to a similar request for a rehearing. It is also likely that other Circuit Courts of Appeals will consider the issue. Ultimately, all signs point to a Supreme Court review of the constitutionality of the SEC administrative law process.

Critics of the 10th Circuit decision point out that if SEC ALJs are found to hold their positions in violation of the Constitution, then potentially hundreds, if not thousands, of prior SEC decisions will be in jeopardy of being invalidated.[19] In addition, as Judge McKay pointed out in his Bandimere dissent, a finding that SEC ALJs are inferior officers could potentially mean that “all federal ALJs are at risk of being declared inferior officers.”[20] Indeed, should the Supreme Court agree with the 10th Circuit ruling, significant changes in U.S. administrative law could result.

Taking heed of these concerns, common sense dictates that the Supreme Court will seek to resolve the Circuit split in a manner that is least disruptive to the administrative law system, which many refer to as the “fourth branch of government.” However history has shown that it is difficult to predict which direction the Supreme Court will sway – especially when its membership is in a state of flux as it is now. Perhaps the Supreme Court will simply order the SEC to modify its appointment process, and hold that any ruling finding the SEC ALJ process to be unconstitutional will only apply prospectively, not retroactively. Such an approach would solve the appointment process problem while preserving the SEC’s ability to uphold previously entered orders.

Special thanks to Herrick law clerk Clifford A. Tatum for his assistance in preparing this alert.

[1] Bandimere v. SEC, 15-9586, 2016 WL 7439007 (10th Cir. Dec. 27, 2016).

[2] U.S. Const. art. II, § 2, cl. 2.

[3] In the Matter of David F. Bandimere, Exchange Act Release No. 9972, 2015 WL 6575665, at * 19 (Oct. 29, 2015).

[4] This issue was also addressed by the Second Circuit Court of Appeals in Tilton v. SEC, 824 F.3d 276 (2d Cir. 2016). In March 2015, the SEC initiated administrative proceedings against private equity magnate Lynn Tilton and certain investment firms for alleged violations of the Investment Advisers Act. Tilton responded by filing suit in federal district court, alleging that the SEC’s ALJs hold their positions in violation of the Appointments Clause. The district court dismissed her complaint for lack of subject matter jurisdiction.  In Tilton, the Second Circuit affirmed the decision of the district court, holding that Tilton had to first raise the constitutional issue in the administrative proceeding and receive a final decision on the issue before seeking federal court review. Id. at 291.

[5] Bandimere,  2016 WL 7439007, at *21.

[6] 832 F.3d 277 (D.C. Cir. 2016).

[7] Bandimere, 2016 WL 7439007, at *4.

[8] 501 U.S. 868 (1991).

[9] Id., at *8.

[10] Bandimere, 2016 WL 7439007, at 8.

[11] Id.

[12] Id. at 21.

[13] Lucia,832 F.3d at 285.

[14] Id. (quoting Landry v. FDIC, 204 F.3d 1125 (D.C. Cir. 2000)).

[15] 204 F.3d 1125 (D.C. Cir. 2000).

[16] Id. at 1133.

[17] Lucia, 832 F.3d at 287.

[18] Bandimere, 2016 WL 7439007, at *14.

[19] See, e.g., Bandimere, 2016 WL 7439007 at *25 (McKay, J., dissenting); David Migoya, Appeals Court Ruling could Nullify Hundreds of Decisions by SEC Judges in Colorado and 5 other States (Jan. 17, 2017, 5:40 PM), http://www.denverpost.com/2016/12/28/appeals-court-sec-decisions.

[20] Bandimere, 2016 WL 7439007, at *25.


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