Quarterly Securities Enforcement Briefing

• 11th Circuit Wrestles With Constitutionality of SEC’s In-House Courts as Supreme Court Declines to Resolve the Issue
• Senate Set to Consider President Obama’s SEC Nominees
• SEC Prioritizes Prosecution of Issuer Reporting and Disclosure Abuses

11th Circuit Wrestles With Constitutionality of SEC’s In-House Courts as Supreme Court Declines to Resolve the Issue
By Conner G. Peretti

We have been following defendants’ challenges to the SEC’s in-house courts, and courts’ efforts to settle the questions, including earlier this year and last year. The SEC has been increasing the use of its in-house administrative proceedings (“in-house courts”) before SEC-employed Administrative Law Judges (“ALJs”). Appeals from ALJ decisions are reviewed by SEC commissioners, before litigants may appeal them to the federal courts of appeal. 

Federal court actions have sprung up challenging the constitutionality of the in-house courts, including on the grounds that  the lack of a jury trial and evidentiary rules violates the defendants’ Seventh Amendment and due process rights, that only the commission itself or the White House can appoint an ALJ, and that  plaintiffs should not have to violate a law or regulation to challenge the SEC in-house court system under the U.S. Supreme Court’s 2010 decision in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010).

On Feb. 24, 2016, the 11th Circuit heard oral argument where the issue was whether a federal district court can even entertain a constitutional claim from a defendant in an SEC proceeding. The agency argued that the defendants had to complete the in-house hearing and internal appeal process before appealing to the applicable federal Court of Appeals. On the panel, Chief Judge Edward Carnes expressed consternation at conflicting Supreme Court rulings that seemed to end in opposite conclusions about whether Congress intended to divest district courts of the jurisdiction to hear constitutional claims against the in-house court system.  The operative provision of the Securities Exchange Act of 1934, which created the SEC, mirrors a provision of the Mine Act that the Supreme Court held precluded district court jurisdiction over constitutional claims. Thunder Basin Coal v. Reich, 510 U.S. 200 (1994). But the Supreme Court also said that the Exchange Act did not express a “fairly discernible” intent to restrict district-court jurisdiction, making the cases difficult to square. Free Enterprise, 561 U.S. at 489. Chief Judge Carnes even said “I just want the Supreme Court to tell me what they want me to do.” However, he will not receive his answer in the near future because on March 28, 2016, the Supreme Court denied to hear a similar constitutional challenge to the SEC’s in-house courts by way of the 7th Circuit. The Supreme Court will likely wait to weigh in until at least the 11th Circuit rules, and perhaps other circuits as well.

Senate Set to Consider President Obama’s SEC Nominees
By John A. Goldmark

On March 15, and in the face of mounting criticism on the backlog of presidential nominees awaiting confirmation, the Senate Banking Committee finally held a confirmation hearing on President Obama’s nominees to the SEC, Democrat Lisa Fairfax and Republican Hester Pierce.

Fairfax and Pierce were nominated last October after two commissioners had stepped down, and if confirmed, would restore the SEC’s commission to five members. Fairfax teaches securities law at George Washington University, and has worked in academia for much of the past 15 years. Pierce is a senior research fellow at the Mercatus Center at George Mason University, and has published a book titled “Dodd-Frank: What It Does and Why It’s Flawed.”

At the confirmation hearing (video available here), the nominees faced sharp questions from senators about how their academic history and research would impact their priorities as members of the top U.S. markets regulator (for example, Pierce has previously criticized portions of Dodd-Frank and related regulations).  The pointed questioning highlighted the intense political scrutiny financial regulators continue to face eight years after the financial crisis. Following the hearing, top Senate Democrats have voiced opposition to the nominees over whether they support requiring public companies to disclose political spending, an issue on which we have previously reported. The SEC’s head, Mary Jo White, has not committed to getting the commission to adopt a political spending disclosure rule. Fairfax and Peirce said the SEC appears to be prevented from approving such a rule by the Republican amendment to last year’s spending bill. Fairfax said she would consider the various arguments on the issue if confirmed. This new opposition to the nominees from top Democrats may serve to further stall their confirmations.
 

SEC Prioritizes Prosecution of Issuer Reporting and Disclosure Abuses
By Jordan A. Clark

On Jan. 25, 2016, Director of Enforcement Andrew Ceresney gave the keynote address at the SEC Director’s Forum. Mr. Ceresney’s address touched on three issues: 1) the SEC’s continued prioritization of enforcement work in the area of issuer reporting and disclosure; 2) the SEC’s renewed focus on gatekeeper enforcement; and 3) the SEC’s new methods for detection of financial misconduct.

First, Mr. Ceresney explained that the pursuit of issuer reporting and disclosure abuses will remain a top priority for the SEC. He grouped the SEC’s enforcement priorities into six categories, with corresponding examples of recent enforcement issues:

• Revenue Recognition
  • Sham revenue transactions, invalid bill and holds, and abuses of specialized accounting methods.
• Valuation and Impairment Issues
  • Failure to incorporate risk in valuation of portfolios and improper accounting of financial assets.
• Earnings Management
  • Fraudulent manipulation of a company’s financial results to meet analyst expectations and listing fake residents to avoid breaching a covenant in a lease to operate certain facilities.
• Missing or Insufficient Disclosure
  • Failure to report executive perks as compensation and concealment of financial impact of student loan program.
• Internal Accounting Controls
  • Violations of internal accounting control provisions of the federal securities laws, even in the absence of fraud charges.
• Clawback of Bonuses and Incentive-Based Compensation
  • Compensation clawbacks where executives engaged in financial reporting misconduct, even where the executives have not been formally charged.

Second, Mr. Ceresney emphasized the SEC’s continued focus on holding gatekeepers accountable for financial misconduct. He explained that the SEC will not prosecute audit committee members and external auditors who make good faith judgments that ultimately prove to be flawed. Rather, the SEC will target gatekeepers who fail to reasonably carry out their diligence responsibilities and who unreasonably fail to comply with relevant auditing standards. Mr. Ceresney advised that audit committee members who learn of inaccurate company filings must take concrete steps to correct the problem and that board members should pay close attention to auditors’ work to ensure compliance and accuracy.

Third, Mr. Ceresney focused on the SEC’s early detection methods. The SEC continues to base the majority of its insider trading actions on referrals from the Financial Industry Regulatory Authority (“FINRA”). The SEC also develops leads through its whistleblower and cooperation programs. However, the newest development in early detection is the SEC’s in-house Corporate Issuer Risk Assessment program (“CIRA”). CIRA is an analytical tool that helps the SEC detect anomalous patterns in financial statements. The program allows SEC staff to compare specific companies to its peers in order to detect abnormal results. The SEC has pursued five actions based upon CIRA, and Mr. Ceresney believes more actions will follow.