July 26, 2018

Securities Alert: What Judge Brett Kavanaugh’s Appointment to the Supreme Court Could Mean for the Securities Industry

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President Donald J. Trump has nominated Judge Brett Kavanaugh to the Supreme Court of the United States.  This Alert examines two of Judge Kavanaugh’s recent opinions regarding SEC enforcement procedures and analyzes how Judge Kavanaugh, if confirmed to the high court, might shape the enforcement road ahead.

A Deep Skepticism of Administrative Enforcement Proceedings 

Last year, Judge Kavanaugh expressed serious concerns about the securities industry’s administrative enforcement process.  In Lorenzo v. SEC, 872 F.3d 578 (D.C. Cir. 2017), the D.C. Circuit Court reviewed an enforcement action against Lorenzo, an investment banking director, who was charged with violating Rule 10b-5 of the Securities Exchange Act of 1934.  Days after Lorenzo had been informed that an issuer’s assets had been devalued, Lorenzo sent two e-mails that had been drafted by his supervisor to prospective investors.  Both e-mails touted the offering’s positive aspects without mentioning that the assets had been devalued.

An Administrative Law Judge concluded that Lorenzo violated Rule 10b-5 because he made false statements about the securities with the intent to deceive investors, and because he had willfully engaged in a scheme to defraud investors.  The ALJ imposed sanctions against Lorenzo, including a lifetime ban from the securities industry.  The SEC affirmed the finding of liability and sanctions.  On review, a majority of the D.C. Circuit court found that Lorenzo did not “make” the misleading statements because he did not have ultimate authority over them, but concluded that Lorenzo nevertheless engaged in a fraudulent act when he sent the statements to potential investors.  The D.C. Circuit upheld the SEC’s decision on liability but vacated the sanctions and remanded the case to reassess the sanctions.

In a scathing dissent, Judge Kavanaugh wrote that the majority’s opinion invoked a standard of deference to the SEC that was akin to “hold your nose to avoid the stink.”  And if it were up to Judge Kavanaugh, he would vacate the SEC’s conclusions as to both sanctions and liability.   Judge Kavanaugh criticized the SEC for a number of reasons.  First, he found fault with the fact that the SEC Division of Enforcement failed to present testimony from Lorenzo’s supervisor or his coworkers regarding the e-mails.  Second, Judge Kavanaugh found that the ALJ’s factual finding were favorable to Lorenzo and should have cleared him of any serious wrongdoing under the securities laws; instead, the ALJ somehow concluded that Lorenzo had willfully violated the securities laws.  In Judge Kavanaugh’s opinion, the ALJ’s factual findings and his legal conclusions “[did] not square up,” and that equated to a violation of basic due process.  Next, Judge Kavanaugh criticized the SEC’s review because it simply discarded the ALJ’s favorable factual findings without hearing any testimony.  Why did the SEC do this, Judge Kavanaugh wondered?  He answered his own question: Because, “…[f]aced with inconvenient factual findings that would make it hard to uphold the sanctions against Lorenzo, the Commission — without hearing any testimony — simply manufactured a new assessment of Lorenzo’s credibility and rewrote the judge’s factual findings.  So much for a fair trial.”  Id. at 598-599 (Kavanaugh, J., dissenting).

Finally, Judge Kavanaugh took a hard look at the constitutionality of administrative review proceedings, finding them in “tension” with the judiciary’s mandate under Article III, the Due Process Clause of the U.S. Constitution, and the right to a jury trial.  Although Judge Kavanaugh recognized that the Supreme Court has allowed administrative enforcement proceedings, there is a premise that those proceedings will be conducted with efficiency and fairness.  But the Lorenzo case, he concluded, “casts substantial doubt on that premise.”  Id. at 602 (Kavanaugh, J., dissenting).

Urging Transparency for Imposing Penalties in Enforcement Proceedings 

One month after Lorenzo, Judge Kavanaugh softened his tone.  In concurring with the D.C. Circuit’s decision in Saad v. SEC, 873 F.3d 297 (D.C. Cir. 2017), Judge Kavanaugh did not raise the same due process issues.  Instead he recognized that FINRA and the SEC have the power to punish brokers with suspension or expulsion, but he also argued that these agencies should explain why the punishment is not excessive or oppressive in each case.

In Saad, a regional director of a FINRA-registered broker-dealer twice misappropriated his employer’s funds and then misled investigators.  FINRA found that Saad’s conversion of funds violated FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade).  As a sanction, FINRA permanently barred Saad from working with any FINRA member firm.  The SEC upheld FINRA’s decision and the sanction.  The D.C. Circuit denied Saad’s petition to modify or set aside the SEC’s decision, but remanded in part with instructions for the SEC to address the effect of the Supreme Court’s decision in Kokesh v. SEC, 581 U.S. __, 137 S. Ct. 1635 (2017) and to determine whether the permanent bar was remedial or punitive.

Judge Kavanaugh’s concurrence tackled the question of whether the sanctions against Saad were “remedial” or “punitive.”  Judge Kavanaugh pointed out that expulsions and suspensions cannot be “remedial” because a lifetime ban is the “securities industry equivalent of capital punishment.”  Saad, at 306 (Kavanaugh, J., concurring).  Therefore, he wrote, the sanctions must be characterized as penalties, and the agencies must justify why the penalties are appropriate in each case.  Courts then will be able to engage in meaningful judicial review of agency decisions imposing harsh sanctions on individuals, and the enforcement process will result in a fairer, more equitable, and less arbitrary system of FINRA and SEC sanctions.  Id.

What Would Supreme Court Justice Kavanaugh Do to Change SEC Administrative Enforcement?

Just last month, the Supreme Court stopped well short of scrutinizing the constitutionality of using ALJs in SEC enforcement actions.  Instead, the split-majority in Lucia v. SEC, 585 U. S. __, 138 S. Ct. 2044 (2018), held that ALJs are “officers” of the United States, rather than mere employees.  Thus, SEC Commissioners — who are appointed by the President — must appoint ALJs rather than delegating that task to SEC staff.   And just two weeks after the Lucia decision, on July 10, 2018, President Trump signed an Executive Order extending the Lucia decision and exempting all ALJs from merit-based competitive service requirements.  The Order empowers agency heads to select ALJs at their discretion under the Appointments Clause.

The Executive Order may put securities enforcement matters back on the Supreme Court’s radar sooner rather than later, and Judge Kavanaugh may find himself ruling on yet another issue relating to administrative agencies.  Judge Kavanaugh’s dissent in Lorenzo suggests that he favors judicial involvement as a way to ensure due process in administrative enforcement proceedings; it remains to be seen whether Judge Kavanaugh, as a member of the Supreme Court, would find that increased executive involvement provides the same protection.  At a minimum, Judge Kavanaugh’s concurring opinion in Saad demonstrates that he is likely to continue to press for meaningful judicial review of administrative decisions imposing harsh penalties.

Keesal, Young & Logan Securities Group

This information has been prepared by Keesal, Young & Logan for informational purposes only and is not legal advice. Transmission of the information is not intended to create, and receipt does not constitute, an attorney-client relationship between you and Keesal, Young & Logan. You should not act upon this information without seeking professional counsel.