Expert Q&A on the Amendments to the SEC’s Rules of Practice for Administrative Proceedings

Practical Law Article w-004-7379 (Approx. 7 pages)

Expert Q&A on the Amendments to the SEC’s Rules of Practice for Administrative Proceedings

by Practical Law Litigation

When did the amendments become effective, and do they apply retroactively?

The amendments became effective on September 27, 2016, and apply to proceedings initiated on or after that date.

For proceedings initiated on or after July 13, 2016 (the date of the amendments) but before September 27, 2016, the amended rules would apply only if within 14 days of service of the Order Instituting Proceedings (OIP), all parties to the proceeding (including the Division) submitted a request to the Secretary that the proceeding be conducted under the amended rules. Otherwise, the former rules would continue to apply

Additionally, certain amended rules apply to proceedings where the hearing had not begun as of September 27, 2016, depending on the stage of the proceeding at that time. The details are set out in Section Q of the SEC’s Amendments to the Commission’s Rules of Practice (Release No. 34-78319; File No. S7-18-15).

What are the main reasons that motivated the SEC to amend its rules of practice?

Since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 expanded the SEC’s ability to bring its enforcement actions in administrative proceedings, the SEC’s Division of Enforcement (Division) has moved aggressively to bring various types of cases in that venue, from accounting fraud to insider trading cases. The growing use of administrative proceedings has brought increased focus on the process and exposed some of its limitations.

Specifically, administrative proceedings have faced criticism that they are fundamentally unfair for respondents. Numerous respondents have challenged the constitutionality of the SEC’s use of administrative law judges (ALJs), and have argued that administrative proceedings lack several safeguards available in federal court. For example, although the SEC often takes years to conduct an investigation, respondents typically had only a few months to review the SEC’s entire investigation file and provide a response. Further, respondents in administrative proceedings could not use all of the pretrial discovery tools available in federal court, such as interrogatories and depositions.

The amendments are intended to address some of the fairness concerns by introducing additional flexibility into administrative proceedings, while continuing to provide for the timely and efficient disposition of these proceedings.

See Practice Notes, Navigating SEC Administrative Proceedings and Defending Against Insider Trading Claims for more on administrative proceedings.

What are the most important changes to the SEC rules governing administrative proceedings?

The key changes focus on provisions concerning:

The timing of the initial decision. Depending on the nature, complexity, and urgency of the case, the presiding ALJ must issue an initial decision within 30, 75, or 120 days from the completion of post-hearing or dispositive motion briefing or a finding of default. The time period for preparation of the initial decision will be designated in the OIP. Previously, the time period ran from the date of service of the OIP. This change has the effect of divorcing the completion of an initial decision from other stages of the proceedings. (SEC Rule 360(a)(2).)
The length of the pre-hearing period. The pre-hearing period has been extended to allow a hearing to begin approximately:
- four months but no more than ten months from the date of service of the OIP, in 120-day proceedings;
- two-and-a-half months but no more than six months from the date of service of the OIP, in 75-day proceedings; and
- one month but no more than four months after service of the OIP, in 30-day proceedings.
(SEC Rule 360(a)(2)(ii).)
Answers to allegations. In addition to any affirmative defenses such as res judicata or statute of limitations, respondents must state in their answer to an OIP whether they are asserting any defense based on reliance on advice of counsel, accountants, auditors, or other professionals in connection with any claim, violation alleged, or remedy sought (SEC Rule 220(c)).
Depositions upon oral examinations. In 120-day proceedings, parties may notice:
- three depositions per side in single-respondent cases;
- five depositions per side in multi-respondent cases; and
- two additional depositions per side under an expedited procedure if the party demonstrates a compelling need.
Depositions are limited to seven-hour sessions, consistent with the Federal Rules of Civil Procedure (FRCP) (FRCP 30(d)(1)). (SEC Rule 233(a), (j).) All deponents must be either a fact witness, an expert witness, or a document custodian (except those SEC personnel who have custody of documents or data that were produced by the Division to the respondent) (SEC Rule 232(e)(3)). Previously, parties received no designated number of depositions and could move for a deposition only if a witness was unavailable to attend or testify at the hearing.
Evidence. Previously, SEC Rule 320 required the exclusion of evidence that is “irrelevant, immaterial, or unduly repetitious.” The amended rule adds “unreliable” to this list of factors. Additionally, the amended rule provides that hearsay may be admitted if it is relevant, material, and bears satisfactory indicia of reliability so that its use is fair. (SEC Rule 320.)
Pre-hearing submissions for expert witnesses. An expert witness must disclose information related to the expert’s background, including qualifications, expert testimony given during the previous four years, and publications authored during the previous ten years. Additionally, the expert must now disclose a written report, containing:
- a complete statement of all opinions the witness will express and the basis and reasons for them;
- the facts or data considered by the witness in forming the opinions;
- any exhibits that will be used to summarize or support the opinions; and
- a statement of the compensation to be paid for the study and testimony in the case.
(SEC Rule 222(b).)
Dispositive motions. SEC Rule 250 now provides that the parties may file three types of dispositive motions at certain stages of an administrative proceeding, with different standards and procedures governing each. Specifically, any party may move for:
- a ruling on the pleadings as a matter of right no later than 14 days after the respondent files its answer (this provision is analogous to a motion filed under FRCP 12(b)(6) or FRCP 12(c));
- summary disposition asserting that there is no genuine issue of material fact and that the movant is entitled to summary disposition as a matter of law, after the respondent files its answer and documents have been made available to it for inspection and copying (a party may move as of right in 30- and 75-day proceedings and only with leave of the hearing officer in 120-day proceedings); or
- a ruling as a matter of law after the SEC’s presentation of its case in chief at a hearing (this provision is analogous to a judgment as a matter of law under FRCP 50(a)).
(SEC Rule 250(a)-(d).) Previously, SEC Rule 250 permitted a respondent to move for summary disposition with leave of the hearing officer if the SEC had not completed presentation of its case in chief. This provision also was used to seek a ruling on the pleadings or dismissal as a matter of law, either early in a proceeding or following the SEC’s completion of its evidentiary presentation at the hearing.

See SEC Enforcement Actions: Comparison of Key Rules for a table comparing the key provisions of the SEC’s amended rules of practice against the pre-amendment rules and analogous provisions and practices applicable in federal court actions.

What challenges remain for respondents in administrative proceedings following the amendments?

In any SEC enforcement action, regardless of venue, the SEC always has an advantage because of the confidential investigative work done under its rules and procedures prior to the authorization of the proceeding.

The amendments take a step in the right direction to address fairness concerns, but several issues remain. For example, respondents continue to face challenges involving:

The limited time to review the SEC’s investigation file. Even though the amendments extended the pre-hearing period to a maximum of ten months in a 120-day proceeding, this timeframe is still quite brief to prepare a response in a complex matter (including determining strategy, identifying, interviewing, and deposing witnesses, obtaining expert testimony, and preparing for the hearing), especially where the SEC’s investigation may have lasted for years and there are large volumes of documents to review.
The limited number of depositions. While respondents may now notice up to seven depositions in multi-respondent 120-day proceedings, this is likely insufficient for complex cases. Indeed, in large, complex matters, the SEC (which has no restrictions on its ability to question witnesses during an investigation) often takes testimony from many more witnesses, sometimes conducting multiple sessions with key witnesses. Further, because of the limited number of depositions available, some respondents in multi-respondent cases might not have the opportunity to identify individuals to be deposed. Perhaps the biggest omission from the amendments is the complete unavailability of depositions in 30- and 75-day proceedings, unless a party files a motion showing that the witness is unable to attend or testify at the hearing. These limitations perpetuate the perception of an uneven playing field in favor of the Division in administrative proceedings.
The admissibility of hearsay evidence. Although multiple commentators argued that the SEC should incorporate the provisions of the Federal Rules of Evidence (FRE) governing the admissibility of hearsay into administrative proceedings, the SEC chose to permit ALJ’s to consider hearsay more broadly, so long as the evidence is deemed relevant, material, and reliable. The admissibility of hearsay is subject to the discretion of the ALJ on a case-by-case basis without specific guidelines for admissibility as in the FRE.
The SEC’s use of information from Wells submissions. The SEC takes the position that it can use the information a respondent provides in a Wells submission as an admission in the administrative proceedings, or in any other manner permitted by the FRE, and specifically exempts Wells submissions from treatment as a settlement communication (for more on the potential risks of making a Wells submission, see Practice Note, Navigating the SEC’s Wells Process).
The SEC’s undisclosed interviews. There is no requirement that the SEC disclose all individuals it interviewed during an investigation or provide summaries of the interviews (such as Form 302s, which report and summarize the interviews conducted by the FBI in a parallel criminal investigation). Therefore, respondents have limited or no ability to seek documents from third-party witnesses who were not subject to the investigation and whose documents are not in the investigation file.

Given the limited number of depositions permitted by the amended rules, what strategies should counsel for respondents use to identify deponents?

Counsel should definitely take the depositions permitted in 120-day proceedings and seek leave for additional depositions as allowed under SEC Rule 233. To effectively identify deponents, counsel should:

Develop a strong understanding of the evidentiary record developed by the SEC and consider:
- the testimony gathered by the staff that is favorable to the defense;
- the testimony that is still needed to bolster the defense theories; and
- the appropriate individuals to provide the missing testimony.
If possible, wait until the SEC selects its deponents to avoid any overlap.
In a multi-respondent proceeding, coordinate with all other counsel in identifying deponents, because respondents in these proceedings are:
- required to notice depositions collectively; and
- allowed no more than five depositions total unless a motion for additional depositions is granted.
Keep in mind that respondents can file a motion with the hearing officer no more than 90 days before the hearing date seeking leave to notice up to two additional depositions. The motion should demonstrate a compelling need for the additional depositions by describing the unique issues or challenges that exist.

What other strategies or best practices should counsel for respondents consider in light of the amended rules?

Counsel should carefully review the amendments and try to be as prepared as possible for the hearing before the case is filed. Additionally, counsel should:

Beware that, under the amended rules, counsel must reveal their experts’ theories before the hearing. The experts will be locked into those opinions, limiting counsel’s ability to adjust “on the fly” if necessary. This will work to the SEC’s advantage.
Seek to develop proof of the unreliability of the SEC’s proffered hearsay evidence. For example, counsel should consider challenging any unsworn statements, interview notes, biased summaries, or incomplete or inaccurate demonstratives.
Take advantage of the various dispositive motions now available as a matter of right in 30- and 75-day proceedings (or with leave in the case of a motion for summary disposition in a 120-day case).

What impact, if any, do you anticipate the amendments will have on parallel federal district court proceedings arising out of the same misconduct?

The amendments will not impact any parallel criminal proceeding arising out of the same misconduct. ALJs are likely to give deference to any attempts by the government to stay the administrative proceeding during the pendency of the criminal matter.

What impact, if any, do you anticipate the amendments will have on the constitutional and other challenges to administrative proceedings going forward?

Complaints about the home court advantage enjoyed by the SEC in administrative proceedings will likely persist notwithstanding the recent amendments. As discussed, respondents in administrative proceedings continue to have fewer discovery rights and procedural protections than their counterparts litigating in federal district court. Further, the amendments do not fully address some of the criticisms asserting that administrative proceedings do not adequately protect the rights of respondents when compared with the civil procedures and evidentiary rules designed to ensure fairness in federal court litigation. Practitioners therefore should expect new and continued objections to administrative proceedings to be raised to the SEC.

Additionally, the amendments likely will have no impact on the constitutional challenges to administrative proceedings. A number of lawsuits have been filed asserting that administrative proceedings are unconstitutional under various theories, but the only argument that had some early success in the lower courts focused on the Appointments Clause in Article II. The SEC appoints all of the ALJs who hear its administrative cases, but their appointment is not done by the SEC Commissioners, in potential violation of Article II.

While the amendments include changes to the rules governing appeals of an ALJ’s decision to the Commission, these provisions serve to more closely track federal appellate court requirements simplifying the institution of the appeal process. The amendments do not change the appointment of ALJs and are unlikely to impact constitutional challenges. (SEC Rules 410-411, 420, 440, 450.)

Further, recent appellate court decisions cast doubt on the viability of the argument that the SEC’s appointment of ALJs is unconstitutional (see, for example, Raymond J. Lucia Cos. v. SEC, 832 F.3d 277, 283-89 (D.C. Cir. 2016)). Therefore, counsel are well advised to assume that for the foreseeable future, administrative proceedings will remain a key part of the SEC’s enforcement strategy.

How might the Trump administration impact the SEC’s authority to pursue cases in administrative proceedings rather than federal court?

It is too early to predict with any detail what impact the Trump administration will have on the SEC’s pursuit of enforcement matters using administrative proceedings. In our experience, the SEC moves slowly when it comes to policy shifts, and changing direction will take time and involve key personnel appointments. However, we think incoming appointees will understand that administrative proceedings do have a place in SEC enforcement efforts, and while they may tweak the system and possibly reduce the overall number of cases brought as administrative proceedings, these proceedings will remain an integral part of SEC enforcement.

Additionally, we may see a reduction in SEC rulemaking, as well as a move away from Chair Mary Jo White’s “broken windows” enforcement policy, which is based on the view that enforcing minor violations of the securities laws helps to prevent more serious violations. However, the SEC already has many investigations in the pipeline, along with a robust whistleblower program that has built momentum since it was established under Dodd-Frank. Also, during President George W. Bush’s administration, massive accounting fraud cases and huge financial fines became the norm in the wake of Enron. Events have a way of guiding policy, despite the desires of the party in power.

Expert Q&A on the Amendments to the SEC’s Rules of Practice for Administrative Proceedings | Practical Law