By virtue of the Administrative Procedures Act, Dodd-Frank, etc., Congress has given the Securities and Exchange Commission broad powers to be investigator, prosecutor, judge, jury and executioner, all in one, in most civil matters before it. Thus, the SEC holds unprecedented powers over the livelihoods of both firms and individuals, registered and unregistered. Any prospective commissioner should be prepared to answer questions on the topics of due process, equal protection and checks and balances regarding prosecutorial conduct within the SEC. Here is a series of questions we have authored. We hope they can be used as part of any future hearings for SEC commissioners.
Eric D. Wanger and Thomas Sjoblom
SEC Nomination Hearings
Thomas Sjoblom and Eric D. Wanger
November 16, 2016
- Scope of Inquiries
It has become routine practice for the SEC enforcement staff to send out subpoenas that ask for every document, email, social media message (SMS) and handwritten note from the time of Adam to the end of the age regarding multiple topics and about every person who might somehow be connected to the matter under inquiry.
This process results in hundreds of thousands of email, SMS, pages of handwritten notes, calendars, telephone records, documents and memoranda. Businesses often spend upwards of $1 or $2 million or more in document recovery and attorney fees to respond.
Efforts to negotiate a trimming down of the request to what is exactly relevant often fail and defense attorneys are criticized—or maybe even sanctioned—for trying to narrow the scope of the subpoena requests.
Q: How can the subpoena process be better managed and more efficient, focused, streamlined and affordable, while still serving the law enforcement needs behind the request?
Q: Would you as commissioner support a policy of better dialogue between the SEC enforcement staff and defense counsel to find more efficient and economical ways of document production, limited to what is relevant and without overburdening businesses?
Q: Would you as commissioner support a policy of more hands-on management by senior people in the division of enforcement and, if need be, the commission, to oversee such large-scale document requests?
- Contacting Clients
It is now routine practice for the SEC enforcement staff to send out letters and questionnaires to clients—or even subpoena client lists—and then start calling clients during the staff’s inquiry. As can be expected, the reaction of clients has a detrimental effect on the business of the person or entity under inquiry. Clients may leave the business or at least harbor suspicion against their investment advisers or brokers under the usual pre-judgment sentiment that “well, if they are being investigated by the SEC, they must have done something wrong.” Inevitably, contacting clients hurts or even kills the business.
Q: As commissioner, what do you see can be done to ensure that the client base of a person or firm is not driven away, even before there is any hearing or trial, while still addressing the need for law enforcement?
- White Papers, Pre-Wells Submission, and Wells Submission
During the later stages of an investigation, the SEC enforcement staff will often entertain a “white paper” or a “pre-Wells submission” from defense counsel intended to bring before the SEC staff matters it may have overlooked or designed to better shape the course of the remaining investigation.
After notification of a possible enforcement action, defense counsel is also given the opportunity to provide the SEC enforcement division with n official a Wells submission, in which defense counsel lays out its view of the facts and law and policy issues that defense counsel perceives are relevant to the outcome of the investigation and possibly referral for enforcement action. Its purpose is to provide the SEC enforcement staff with defense counsel’s view of the evidence and law and policy issues. In the past, that Wells submission has been attached to the SEC staff’s action memorandum to the commission when the staff sought authority to commence an enforcement proceeding.
As the July 2015 report of the U.S. Chamber of Commerce noted, however, it is unclear whether and to what extent the commission itself actually receives and makes use of such Wells submissions as part of its deliberative process.
Q: As commissioner, would you support the need for the staff to provide all such submissions to senior managers in the division of enforcement and the commission as early in the investigative process as possible, and if need be, support an amendment to the SEC’s rules of practice both allowing white papers and pre-Wells but also requiring the staff to provide all such submissions directly the commission?
Q: As commissioner, would you require that the enforcement staff provide these submissions to the commission in their entirety without omitting or otherwise “scrubbing” such documentation?
- Reverse Proffers
In criminal proceedings, attorneys at the Department of Justice often will provide to the defendant a “reverse proffer,” in which the DOJ staff lays out its evidence against the person who is the “target” of the DOJ’s investigation. This gives the “target” of the investigation an opportunity to fairly assess the merits of the government’s case against him or her.
In SEC enforcement cases, however, there is no uniform practice to do so. More often than not, the SEC staff refuses to make any such reverse proffer of the government’s case and sometimes pressures the subject of the investigation into an unfavorable settlement while holding back evidence that would otherwise be helpful to the subject of the investigation.
Q: As commissioner, would you support the practice of making a “reverse proffer” by the staff to the subject of the investigation and require that policy be implemented across all regional offices?
Q: As commissioner, would support an amendment to the SEC’s rules of practice so that more productive use of reverse proffers are made?
- Brady, Giglio and Jencks Materials
The current practice of the SEC enforcement staff is not to provide any information that tends to show the innocence of a person or otherwise exonerate him—known as Brady and Giglio materials—until late in the process and sometimes not until the administrative proceedings are actually commenced. In addition, prior statements of witnesses obtained by the SEC staff—known as Jencks materials—may not be provided until after the witness actually testifies, or not provided at all if the witness is not called by the SEC staff to testify. Such materials then never see the light of day, even though they may be helpful to the defendant.
Q: As commissioner, would you support a new policy that defense counsel receive all such evidence much earlier in the process—indeed, prior to the Wells notice and during the investigation itself—so that defense counsel can properly represent its clients and adequately prepare its defense and its Wells submission to the commission?
The SEC enforcement staff continues to claim that if the “subject” of the investigation cooperates, it will receive cooperation credit at the end of the investigation. The grant or denial of cooperation credit, however, varies from staffer to staffer and between different regional offices. Because of this lack of uniform treatment, the perception in the industry is that this is just an illusory promise, to which the staff more often than not pays lip service, but in reality is used more as a Sword of Damocles to force settlement. The staff intones cooperation credit, but then penalizes the subject the same as if it had not cooperated.
Q: If there is a grant of cooperation credit, how would you quantity the extent of reduction in sanction or penalty?
Q: Would you as commissioner support the adoption of a uniform standard across the commission for all its staff and all its offices?
Lack of Due Process in In-House Administrative Proceedings
- Contacting Potential Witnesses to be Called by the Defense
Defense lawyers have complained to the congressional staff that the SEC enforcement attorneys sometimes tell witnesses that the SEC staff would prefer if such witnesses talk only to the SEC staff and not to the defense lawyers. At other times, after speaking to the SEC staff, some witnesses who work for regulated entities (such as broker-dealers or investment advisers) are fearful of retribution or other regulatory consequences from the SEC staff if the witness were to appear on behalf of the respondent or the defendant.
Q: Would you support or condone the SEC staff calling witnesses who may wish to appear on behalf of the respondent or defendant and support behavior where the enforcement staff suggests to witnesses that the staff would prefer if such witnesses only spoke to the SEC staff?
Q: Do you think that such law enforcement initiatives are consistent with constitutional due process?
Q: Do you think that a fair hearing can be had before the in-house ALJs when the SEC staff cautions witnesses against talking to anyone other than staffers?
Q: How can defense lawyers bring forward critical evidence in support of their client’s case if the SEC staff cautions witnesses about whom to talk to?
Q: How do you intend to monitor such behavior on the part of the SEC staff?
Q; If you discover that such practices are going on, what are your plans to stop it?
- Discovery Depositions by Defense Counsel
Under the SEC rules of administrative proceedings as currently written, defense counsel are entitled to deposition testimony prior to the hearing only when the witness is otherwise unavailable to appear at that hearing. While the commission has proposed certain rule changes that would permit 3 depositions in a case involving a single respondent, or 5 depositions in cases involving multiple respondents, the Commission is still being criticized for failing to meet the same due process standards that prevail in federal courts.
Even though the SEC enforcement division typically claims as justification for its practices that defense lawyers and their clients can have access to the transcripts of testimony taken by the SEC staff during the investigation, those transcripts are limited only to what the SEC staff knows, and there will be no cross examination to check the witnesses’ memory, clarify answers and check the veracity of the witness’ memory.
Q: Why should the SEC think that it can limit and control the number of witnesses who defense counsel wish to depose, especially when the SEC staff has had the opportunity during the investigation to interview and take investigative testimony from 10, 20 or even 50 witnesses in some cases?
Q: Why should the SEC staff be permitted to control the content of testimony and require defense counsel and their clients to accept the work of the staff alone?
Q: Do you subscribe to the current practice of using those transcripts to win summary adjudication before the in-house ALJs—that is, the SEC’s current rules of practice that permit the SEC enforcement division to win on the basis of its own developed records without ever holding any sort of evidentiary hearing?
Q: Does such a system seem fair and consistent with due process of law?
- Section 929U of Dodd Frank Act
Section 929U of Dodd-Frank provides that the SEC staff must commence its enforcement action within 180 days the Wells notice is made, unless the staff makes a determination that the case is “complex” and therefore needs more time to investigate.
In a recent case, a respondent in an administrative proceeding asked that the ALJ authorize a subpoena to be issued against the enforcement staff on the issue of “complexity.” The staff opposed the request on the grounds, among others, that such a determination is a matter of governmental privilege and work product. The staff also argued that the statute is not a statute of limitation but only an internal guideline.
When the ALJ ruled against the respondent, he petitioned the commission for interlocutory review, but the commission denied the request, saying that there was no controlling issue of law.
Q: Do you think that the staff should be permitted to circumvent the 180-day restriction under 929U and then deny the respondent the right to find out why the case was so complex that the 180-day requirement can be avoided?
Q: Do you think that the 180-day requirement should only be an internal staff guideline and not function as a statute of limitations?
- Biased ALJs
The press, including the Wall Street Journal and the New York Times, as well as respected magazines, such as the Economist, have published articles noting the existence of pro-enforcement biased ALJs. Such a system cannot long hold the respect of the securities industry it seeks to regulate, nor the respect of onlookers. In 2014, the SEC brought more than one–half of its cases before the in-house ALJs and the SEC has announced that it plans to bring more cases in-house.
Q: What will you do as commissioner to ensure that the administrative process of the SEC and its ALJs correct the partiality currently being enjoyed by the enforcement staff before its ALJs , and what will you do to ensure that ALJs practice the impartiality required of a fair adjudicative system?
Q: What will you do to correct the current view that appointing ALJS to work as employees of the SEC violates the appointments clause of the Constitution?
- Combining the Functions of Legislator, Investigator, Prosecutor, Judge, Trier of Fact, and Appellate Body—All in One at Same Agency
The SEC staff serves as legislator, investigator, prosecutor, trier of fact, judge, and appellate body—all rolled up in one entity. In no other system in this country do we allow all such functions to held by one person or one entity at the same time. It is inconsistent with the Constitution and notions of fairness and due process.
When litigants have brought this issue before the federal courts, the courts have held that Congress set up this system and the courts are powerless to rectify it. It is up to Congress to separate those functions.
Q: Do you think the SEC’s combined functions can function fairly? If they think so, what about public perception that disbelieves it?
Q: Should Congress address this issue and remedy it?
Broken Windows Enforcement Policy
The SEC has been pursuing a “broken windows” enforcement policy for the last several years, under which no violation is too small to escape investigation and prosecution.
There was one example in a case concerning one of my constituents, a small but growing investment adviser. The SEC enforcement staff, following a referral by the company to antagonize him over an internal corporate mismanagement and takeover fight, commenced an investigation that lasted more than two years. In the end, the enforcement staff claimed that there had been an overstatement of the investment adviser’s performance fees by a whopping $2,269. Let me repeat: $2,269! To make its case, the staff resorted to exaggeration and embellishment. After denying him due process and “cornering” him into submission, the staff settled with him. He agreed to a bar with right to reapply after one year. The effect of the SEC investigation and prosecution was the destruction of a long-term opportunity fund, destruction of an investment adviser, and destruction of a multi-family office with a $300 million client base that had been growing at the rate of $100 million per year. All employees quit or had to be let go.
So, here are my questions:
Q; Do you think the resources of the SEC enforcement staff should be used to investigate for 2 1/2 years and then prosecute such small matters, especially when they lead to the destruction of small businesses and dislocation of valuable clients and their funds?
Q: Do you think that it is good public and regulator policy to engage in such aggressive enforcement actions that the SEC disrupts or even destroys growing businesses?
Q: On what basis can the SEC possibly justify such aggressive enforcement action against small entrepreneurs when larger frauds and crimes, such as those we saw during the global meltdown in 2009 through 2012, are ignored?
Cancellation of Credit Cards, Bank Accounts and Brokerage Accounts
In the case we have been discussing involving one of my constituents, following settlement of the enforcement action, in which he neither admitted nor denied any wrongdoing and in which the SEC staff was never required to prove a single fact, he was notified by his banks that his credit card was cancelled, he was told by his brokerage firm that his brokerage account would be closed, and yet another bank and another brokerage firm informed him that both his IRA and SEP-IRA accounts would have to be transferred out of their respective bank and brokerage houses to other entities.
When he inquired about why this was happening, he was told that, given his settlement of the SEC enforcement action, even though nothing was ever proved and it concerned only $2,269, he was simply too great of a business and reputational risk to retain as a customer. They feared heightened regulatory scrutiny and possible repercussions from the SEC. He would have to go elsewhere.
Q: Do you think it is proper that the regulatory climate has reached such a fever pitch that the banking and brokerage industry operate in fear of the SEC, and feel compelled to expel their clientele?
Q: Do you think that is good public policy?
Q: Do you think that the SEC’s enforcement actions should have such in terrorem effect that banks and brokerage firms force their clients to leave them?
Mutual Funds and Investment Adviser
In prior years, the SEC examination staff would undertake field exams to help the industry identify problem areas at mutual funds and investment advisers and help those entities rectify any weaknesses. In recent years, however, there has been a notable shift in attitude—away from being helpful to the “undercover cop on the beat” mentality. It has been reported to the committee staff that many mutual funds and investment advisers now fear the arrival of the SEC exam staffers, knowing that they are on site to find something—anything—for which they can bring an enforcement action. Legal and consulting costs have soared in this new enforcement-minded environment.
In the case I mentioned previously, following settlement of the enforcement action regarding the fund and the investment adviser, the SEC exam staff showed up at the multi-family office, purportedly to do an “examination,” but which all the employees knew—and feared—was a hidden enforcement action.
Q: Has the SEC now become the “Eagle on the Street,” as the SEC’s own movie once so aptly portrayed it, to such an extent that the industry fears it?
Q: How does the SEC expect to maintain a healthy working relationship with the industry if it now views the SEC simply as cops looking to unearth something with which to prosecute it?
Q: How does the SEC expect the industry to grow and flourish in such an environment? Or, is the SEC only concerned with letting “too big to fail” continue and weeding out the smaller firms?
Q: Year after year, the SEC asks for an increase in its budget, which has grown from $1.02 billion in 2010, following the global meltdown, to $1.5 billion in 2015. For 2016, the SEC requests $1.7 billion, another 15 percent increase. For FY 2016, the SEC is requesting 93 new positions for the division of enforcement in three areas: (1) staff proficient in conducting intelligence processing and analysis, (2) investigative staff to permit the agency to more swiftly and effectively identify and respond to the high volume of securities-related misconduct, and (3) litigation staff to reinforce the growing number of contested enforcement matters nationwide.
Recent articles, however, such as the one that appeared in Economist on November 7, 2015, report that the enforcement figures are less impressive than they appear at first glance. For example, a professor at Emory University has questioned the validity of the reported numbers. For the years 2000 through 2014, Professor Urska Velikonja reports that the SEC inflated its numbers by as much as 23 to 34 percent by double counting and other forms of padding.
Q: How can Congress properly allocate hard-earned taxpayer dollars to needed enforcement initiatives when we cannot trust the statistics used by the agency to support budget increases?
Q: Should Congress undertake a full-blown investigation of the SEC into the figures used to support its budget requests?
Q: Don’t you think that the SEC’S budget would be better spent on larger frauds and more serious problems than simply looking for broken windows?