On Tuesday, December 27, 2016, the United States Court of Appeals for the Tenth Circuit in Bandimere v. S.E.C., found that the Securities and Exchange Commission’s (“SEC”) use of administrative law judges (“ALJs”) violated the U.S. Constitution.  While the court’s opinion relies on a somewhat arcane question of administrative law—whether the hiring of SEC ALJs violated the Appointments Clause—its decision to set aside an SEC order imposing sanctions for securities laws violations raises significant questions about future SEC claims brought before ALJs rather than in federal courts, as well as prior adjudications.  With the D.C. Circuit currently considering whether to grant rehearing en banc on its recent holding that these same SEC proceedings were constitutional, the Tenth Circuit’s decision is sure to draw considerable scrutiny in the months ahead and may well give rise to Supreme Court review of the issue.

The SEC’s Use of Administrative Law Judges

As previously discussed on this blog, the SEC Division of Enforcement has increasingly favored bringing claims before ALJs rather than in federal civil court after the 2010 Dodd-Frank Act expanded SEC ALJs’ jurisdiction and authorized them to impose new penalties.  Whereas the SEC brought more than 65% of its enforcement actions against public company defendants in federal civil court between 2010 and 2013, the proportions have since inverted.  In 2015, 76% of actions against such defendants were brought before ALJs.

While initial decisions by SEC ALJs are not necessarily binding, ALJs exercise considerable power and discretion in carrying out their duties, such as issuing subpoenas, ordering depositions, ruling on evidentiary issues and dispositive motions, and otherwise regulating the course of the hearing.  After hearings, the ALJ prepares an initial decision containing factual findings and legal conclusions, along with an appropriate order, and the SEC then either delivers its own decision or simply adopts the ALJ’s as final.  These SEC ALJ proceedings offer streamlined procedures compared to federal courts, but critics have complained that speed comes at the expense of fairness to respondents and that ALJs are more likely to find in the SEC’s favor.

In response to the perceived unfairness of these administrative proceedings, a number of respondents in recent years have attempted to challenge the SEC’s use of ALJs, primarily by attacking their constitutionality under the Appointments Clause.  While most of these lawsuits have been dismissed for jurisdictional reasons, two appellate courts have recently addressed the issue—but reached opposite conclusions.  In August, the D.C. Circuit found that the SEC ALJs were constitutional in Raymond J. Lucia Cos. v. SEC, 832 F.3d 277 (D.C. Cir. 2016), but the Tenth Circuit disagreed earlier this week, finding them unconstitutional in Bandimere.

The Constitutionality of SEC Administrative Law Judges

In order to ensure accountability of “inferior officers” who carry out government duties, the Appointments Clause of the Constitution requires that they be appointed by the President, a court, or a department head.  If someone is merely a government employee, however, there is considerably more flexibility in the hiring process.  The issue in these cases arises from the fact that SEC ALJs are not appointed by one of the enumerated offices in the Appointments Clause, but rather picked through a merit-selection process.  If SEC ALJs merely function as employees, this selection process is constitutional, but if they have the powers and responsibilities of “inferior officers,” their appointment must be consistent with the Constitution.

But according to some people and companies charged with securities law violations in SEC proceedings, the ALJs do in fact function as inferior officers.  The Supreme Court has explained that an appointee is an officer, as opposed to an employee, if he or she exercises significant authority pursuant to the laws of the United States, which depends in large part on the discretion and powers they are granted.  See Freytag v. Commissioner, 501 U.S. 868 (1991); Buckley v. Valeo, 424 U.S. 1, 126 (1976).

The two appellate courts to address this issue reached opposite conclusions.  In August 2016, the D.C. Circuit sided with the SEC, holding that SEC ALJs are employees because they lack the power to issue final decisions, which that court had previously held to be a dispositive factor in distinguishing employees from inferior officers.  Rather, any final decision requires an order issued by the Commission.  Earlier this week, however, a split panel of the Tenth Circuit disagreed that final decision-making power is the sine qua non of an inferior officer.  Rather, given the considerable power and discretion exercised by SEC ALJs in shaping the administrative record that is ultimately before the Commission, the majority found that the ALJs were inferior officers that must be appointed pursuant to the Appointments Clause.

In a cautionary dissent, however, one Tenth Circuit judge expressed concern that the majority’s opinion put “all federal ALJs,” such as the 1,537 Social Security Administration ALJs, “at risk of being declared inferior officers.”

The Future of Administrative Law Judges in the SEC and Beyond

The Bandimere decision is a significant one, but it may not be the final word: the SEC can—and likely will—petition the Tenth Circuit for rehearing en banc or seek Supreme Court review.  While petitions for both rehearing en banc and certiorari are granted sparingly, Judge McKay’s dissent may draw attention to the circuit split and encourage further review.  Indeed, a petition for rehearing en banc in Raymond J. Lucia Cos. is currently pending before the D.C. Circuit, which may be inclined to grant rehearing in order to defend its Appointments Clause jurisprudence and address the Tenth Circuit’s analysis.  Particularly given the similarities between SEC ALJs and other administrative law judges elsewhere in the executive branch, a circuit split on this issue could create considerable uncertainty in the myriad proceedings conducted by administrative agencies throughout the country, making Supreme Court review more likely.

Even if the Tenth Circuit’s interpretation of the Appointments Clause prevails, the long-term effects of the decision could still be relatively minor.  As the concurring opinion in Bandimere noted, courts addressing constitutional infirmities with agencies generally seek the “minimum relief necessary to bring administrative overreach in line with the Constitution,” as demonstrated by successful challenges to the constitutionality of the Public Company Accounting Oversight Board and the Consumer Financial Protection Bureau.

In the coming months, however, Bandimere will likely spur more resistance to SEC proceedings, encouraging more respondents to object to the use of ALJs and to appeal any unfavorable adjudications.  As these challenges proceed through the courts, it remains to be seen whether the SEC will choose to pursue future securities laws violations in administrative proceedings at the same rate as in the past several years, or whether this decision presages the SEC’s return to the federal courts for the majority of its cases.  Indeed, the SEC’s direction may be changed even more significantly by President-elect Donald Trump.  Notably, House Republicans have opposed the use of SEC ALJs in the past, proposing legislation to provide respondents in SEC administrative proceedings an automatic right of removal to federal court.  We will have to wait and see if Mr. Trump’s SEC appointees share a similar view.