SEC Secures Split Decision in Insider Trading Trial

The SEC received a split decision from a jury in an insider trading case that spawned three separate enforcement actions and ten different traders. The jury found in favor of the Commission and against one first tier tippee – one who obtained his information directly from the tipper – and against the agency and in favor of a second tier tippee. SEC v. Melvin, Civil Action No. 1:12-cv-02948 (N.D. Ga. Verdict entered Fe. 17, 2017).

The action centered on the tender offer by French pharmaceutical company Sanofi-Aventis for Chattem, Inc., announced on December 21, 2009. The offer was for $93.50 per share, a 32.60% premium over the closing share price the day before the announcement. In November 2009 the Chattem board members were informed that Sanofi had a serious interest in acquiring the company. The next month one of its board members consulted with his personal accountant, defendant Thomas D. Melvin, Jr., about 50,000 Chattem options he held that would be automatically exercised if there was a change in the ownership of the company.

After learning about the deal Mr. Melvin is alleged to have told four individuals about the pending deal. Each traded and was named in one of the three enforcement actions that emanated from the initial tips. Mr. Melvin is alleged to have tipped: Charles Cain, his longtime broker, who purchased 1,500 shares of Chattem which yielded $36,680.10 in trading profits following the announcement; Joel C. Jenks, a close friend, who purchased 1,000 shares of Chattem which yielded $24,337.43 in trading profits; R. Jeffrey Rooks, his partner at the accounting firm who purchased $16,000 in Chattem shares, yielding trading profits after the announcement of $6,020.39 and was named as a defendant in a separate action; and C. Roan Barry, a close friend who purchased 1,700 shares which yielded $41,859.71 in trading profits following the announcement and was also named in a separate action.

Each person tipped by accountant Melvin is alleged to have tipped another: Mr. Cain told his friend, defendant Peter Doffing, named as a defendant in the Melvin case, and an unidentified individual; Mr. Doffling purchased out of the money call options which yielded trading profits of $378,979.32 following the deal announcement; the unidentified individual bought 250 shares which yielded $5,877.35 in illicit trading profits; Mr. Jenks is alleged to have tipped another unidentified individual who purchased call options which yielded trading profits of $38,802.71; Mr. Rooks tipped another unidentified individual who purchased 725 shares of stock which resulted in $12,461.75 in illicit trading profits; and Mr. Berry tipped Ashley J. Coots, a friend and neighbor who, in turn tipped Casey D. Jackson and another person. Mr. Coots purchased 540 shares of Chattem which resulted in $13,231.40 in illicit trading profits while Mr. Jackson bought 100 shares which yielded $2,369.78 in trading profits; the other person tipped by Mr. Coots bought 165 shares yielding $4,128.63 in profits following the deal announcement.

The complaint against defendants Melvin, Cain, Jinks and Doffing alleged violations of Exchange Act Sections 10(b) and 14(e). The Melvin case went to trial. Prior to that time defendants Melvin and Cain settled. Each agreed to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 14(e). Defendant Melvin also agreed to pay disgorgement, on a joint and several basis with Mr. Cain, of $36,991.20 along with prejudgment interest, and $28,840.75 on a joint and several basis with Mr. Jenks, also with prejudgment interest. In addition, Mr. Cain agreed to pay a penalty of $36,991.20.

Messrs. Jinks and Doffing went to trial. The jury returned a verdict in favor of Mr. Jinks and against Mr. Doffing.

See also SEC v. Coots, Civil Action No. 1:12-cv-02986 (N.D. Ga. Filed Aug. 28, 2012); SEC v. Jackson, Civil Action No. 1:12-cv-02987 (N.D. Ga. Filed Aug. 28, 2012); SEC v. Rooks, Civil Action No. 1:12-cv-02988 (N.D. Ga. Filed Aug. 28, 2012). Defendants Berry, Coots, and Rooks settled with the Commission. Each consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 14(e). Mr. Jackson also settled, consenting to the entry of an injunction based on Exchange Act Section 10(b). In addition, each agreed to pay disgorgement, prejudgment interest, and a penalty as follows: Mr. Barry, $55,091.51 and a penalty in the same amount; Mr. Coots $17,360.51 and a penalty of $13,231.80; Mr. Jackson $2,369.78 and a penalty of $1,184.89; and Mr. Rooks $18,482.14 and a penalty of $4,620.54. Mr. Rooks also agreed to be barred from appearing and practicing before the Commission as an accountant. His settlement reflects his cooperation with the Commission.

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Were SEC ALJs Appointed In Violation of the Constitution?

Challenges to the SEC’s authority to move its enforcement program in-house before Administrative Law Judges and out of the federal courts just took a new turn. While the SEC had one win on challenges to the appointment of its ALJs under the Constitution’s Appointments Clause and one loss, that may be about to change.

Previously, the DC Circuit ruled in favor of the Commission, rejecting a claim that its ALJs were not properly appointed. Raymond J. Lucia Companies, Inc. v. SEC, No. 15-1345 (D.C. Cir August 9, 2016). Subsequently, the Tenth Circuit handed the agency a loss, concluding that the ALJ’s were appointed in violation of the U.S. Constitution. Bandmere v. SEC, No. 15-9586 (10th Cir. December 27, 2016). While many thought the next battle ground on the issue would be the Supreme Court, the D.C. Circuit changed all that. The Circuit Court vacated its earlier decision in Lucia Companies and ordered that the case be reheard en banc with argument set for May 24, 2017, in an order entered on February 16, 2017. If the D.C. Circuit sides with the Tenth Circuit, it could spell the beginning of the end for SEC administrative proceedings, at least for a period. The arguments on each side of the issue are highlighted by the D.C. Circuit panel decision in Lucia Companies and that of the Tenth Circuit in Bandmere.

The Lucia Companies panel decision

The case was before a panel of the Court on a petition to review a decision of the Commission that followed a hearing before an ALJ. The Order Instituting Proceedings alleged that the firm violated the antifraud provisions of the Advisers Act in marketing its retirement wealth strategy to prospective clients. Following a hearing the ALJ issued an initial decision finding liability on one of four charges. Sanctions were imposed, including a lifetime bar. The Commission sua sponte remanded the case for further findings on the three charges the ALJ had not addressed. A revised initial decision was issued. After granting a petition for review the SEC concluded that petitioners had violated the antifraud provisions. It rejected a claim that the administrative proceeding was unconstitutional because the ALJ had been appointed in violation of the Appointments Clause.

A panel of the Circuit Court considered the Appointments Clause issue, noting that the government had not claimed that the agency decision could be upheld if the presiding ALJ was unconstitutionally appointed. To the contrary, the Commission acknowledged that the ALJ was not appointed in accord with the Clause. It did not argue harmless error.

The Appointments Clause provides that the President “shall nominate, and with the Advice and Consent of the Senate, shall appoint . . . Officers of the United States, whose Appointments are not herein otherwise provided for . . . but the Congress may by Law vest the Appointment of such inferior Officers . . . in the President alone . . .” All officers of the United States are to be appointed in accord with the Clause unless provided for elsewhere in the Constitution. This includes executive officers, judicial officers and those of administrative agencies. Only those who are “lesser functionaries” need not be appointed in accord with the Clause. This is an important structural safeguard of the Constitution, the Court noted.

Generally, the appointee is considered an Officer rather than an employee if he or she exercises “significant authority pursuant to the laws of the United States.” (internal citations omitted). In assessing the appointee’s authority, it is important to look at the facts of the particular case and also the duties of the person. If the appointee’s position was established by law and the position’s duties are specified by statute the critical question is the meaning of “substantial authority.” Three criteria are considered: 1) the significance of the matters resolved by the official; 2) the discretion exercised in reaching decisions; and 3) the finality of those decisions.

Here the critical question is the finality of the decisions. Under Exchange Act Section 78d-1 the Commission has the authority to delegate any of its functions to a division, an individual or an employee. Section 78d-1(c) specified that when the ALJ’s determination is not reviewed it “shall . . . be deemed the action of the Commission.” Petitioner claims that this provision substantiates their point regarding the Appointments Clause. Under the Commission’s rules, however, “[u]ntil the Commission determines not to order review . . . there is no final decision that can ‘be deemed the action of the Commission.’” 15 U.S.C., Section 78d-1(c). Therefore the initial decision only becomes final when the Commission issues the finality order. “Put otherwise, the Commission’s ALJs neither have been delegated sovereign authority to act independently of the Commission nor, by other means established by Congress, do they have the power to bind third parties, or the government itself, for the public benefit.” Accordingly, they need not be appointed in accord with the Appointments Clause. The petition for review was denied.

The Tenth Circuit ruling in Bandmere

David Bandmere was found to have violated the federal securities laws following a hearing before an ALJ. Mr. Bandemere was then directed to cease and desist from further violations of certain provisions of the federal securities laws. He was also barred from the securities business for life. The SEC affirmed. In ruling on his claim that the ALJ had not been appointed in accord with the requirements of the Constitution’s Appointments Clause, the SEC agreed but concluded that the ALJ was not an inferior officer within the meaning of the Clause. Thus, the Appointments Clause does not apply to SEC ALJs, according to the Commission.

The Tenth Circuit granted the Petition for Review, finding that under Frytag v. Commissioner of Internal Revenue, 501 U.S. 868 (1993) SEC ALJs are inferior officers within the meaning of the Clause. First, the court reviewed a number of decisions in which officials at other agencies had been held to be inferior officers within the meaning of the Appointments Clause. Those included a district court clerk, an assistant-surgeon, a commissioner of the circuit court, Federal Election Commission commissioners, and others.

Second, the court concluded that Frytag, in which special trial judges at the Tax Court were held to be inferior officers within the meaning of the Clause, to be dispositive. There the Court found three factor which, when taken together, were determinative of the question. Those factors are: 1) if the position was created by law; 2) whether the duties, salary and means of appointment for that office are specified by statute; and 3) the nature of the duties performed – are they more than ministerial. No one factor is dispositive under this approach.

In this case, three factors taken together establish that SEC ALJ’s are inferior officers. As the court held: “In sum, SEC ALJs closely resemble the STJs described in Frytag. Both occupy offices established by law; both have duties, salaries, and means of appointment specified by statute; and both exercise significant discretion while performing important functions that are more than ministerial tasks . . . Further, both perform similar adjudicative functions. . . We therefore hold that the SEC ALJs are inferior officers who must be appointed in conformity with the Appointments Clause.” (internal quotations and citations omitted).

In reaching this conclusion the court rejected the SEC’s claim that because SEC ALJs cannot make a final decision, they are not inferior officers. That approach would make one factor dispositive a the expense of the others. Such an approach is not consistent with Frytag, the court concluded.

Discussion

The stakes surrounding the Appointments Clause question are significant. Prior to the D.C. Circuit’s order granting rehearing en banc it appeared that the Appointment Clause question was heading for the Supreme Court since there was a clear split in the circuits. For the moment, however, the question of the validity of the SEC ‘s administrative proceedings is on hold.

If the en banc D.C. Circuit agrees with the Tenth Circuit the two decisions would represent substantial authority for the proposition that SEC ALJs were appointed in violation of the Constitution. While the Commission would undoubtedly seek Supreme Court review because of the significance of the question, there would be no clear split in the circuits requiring review at this time. Perhaps more importantly, even assuming a stay of the en banc decision is granted, the SEC could be hard pressed to move forward with its administrative cases. This is particularly true given the posture of the Lucie Companies case in which the SEC admitted its ALJ’s were not appointed in accord with the requirements of the Appointments Clause and it chose not to argue harmless error.

If the D.C. Circuit essentially reiterates the panel decision, finding that the SEC ALJs need not be appointed in accord with the dictates of the Clause then again there would be a clear split in the circuits. In that event the Supreme Court may chose to take up the issue. Again, the importance of the issue would bolster the change that the High Court would hear the case. If the Supreme Court chose to take up the question SEC administrative proceedings would be clouded with uncertainty during the months of briefing and argument leading to a decision.

Finally, if in fact SEC ALJ’s have been appointed in violation of the Clause, a critical question not addressed by either Court is remedy. Since the SEC has not claimed the benefit of the harmless error doctrine the agency could not just continue with the status quo. In the future ALJs would have to be appointed in accord with the dictates of the Clause. But other issues remain. For example, what would be the impact on the Initial Decisions rendered by the ALJs which are awaiting appeal? Do all of those cases have to be reheard? Likewise, what happens to the cases pending before ALJs that are at various stages of the pre-hearing process? Do all of those proceedings have to be reinstituted once the SEC’s ALJs are properly appointed? And, what happens to prior cases heard by ALJs that have become final? Do those proceedings have to be reopened? These and other questions highlight the significance of the issue and the potential impact of the decisions.

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