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The SEC’s Fairness Problem

The Securities and Exchange Commission facade, reflecting a row of flags
The Securities and Exchange Commission. Photo by Flickr user Scott S.

The Securities and Exchange Commission may or may not have a problem with the fairness of its internally run court system. It certainly has a problem with the appearance of fairness - or the lack thereof.

The SEC hires its own judges to hear some of its own civil complaints against bankers, advisers and others subject to the commission’s jurisdiction; other civil cases are either settled or litigated in regular federal courts. The SEC’s in-house judges are meant to reach initial determination about the culpability of defendants in administrative proceedings, and the SEC has characterized their judges as “mere agency employees” who “play only a part in a process over which the Commission retains control from start to finish.” This distinction is the defense the SEC has relied upon in countering accusations that the way the judges are appointed is unconstitutional. Just having in-house judges, though, is not the real problem.

The problem is that the SEC determines which cases are assigned to these judges, thus giving the commission a home court advantage that has clearly been borne out in the court’s long-term statistics, as The Wall Street Journal has thoroughly reported.

Since Dodd-Frank was passed in 2010, the SEC has leaned more heavily on its internal tribunal system, taking advantage of rules allowing it to handle a broader range of cases as in-house administrative proceedings. According to the Journal, the SEC has won 86 percent of cases in which defendants contested cases within its own courts. That rate is 70 percent for cases heard in federal court. The first Journal story on these skewed results, which appeared in May, has triggered additional scrutiny from the media and the legal community.

Under this criticism, SEC Chairwoman Mary Jo White acknowledged the need to “modernize” the way the in-house court system functioned, but defended the process as “very fair.”

The SEC has claimed that it relies more heavily on in-house courts mainly for the sake of efficiency. But this would not necessarily change if defendants were given the right to choose whether to contest a case before SEC judges or in federal court. Defendants in the SEC’s cases, after all, usually have even more reason to value efficiency than does the commission itself, since they typically pay the legal costs with their own money - or that of their employers - rather than with taxpayer funds. If the SEC merely proffered a complaint and allowed the respondent to choose how to contest the charge, the appearance of unfairness would vanish.

Some congressional lawmakers have aimed to legislate the SEC into fairness. Rep. Scott Garett, R-N.J., recently introduced a bill to curtail SEC administrative proceedings sharply, more or less forcing any contested case into federal court. This is a heavy-handed solution, and probably more than is necessary, but it illustrates the magnitude of the SEC’s current image problem. Other agencies use administrative judges too; putting the choice in defendants’ hands would make the process fairer while not forcing everyone down the more contentious and expensive path of litigation in federal court.

There is reason to think this change would work, because it parallels the system that is used in enforcing tax law. An Internal Revenue Service auditor may propose adjustments to a taxpayer’s liability. If the taxpayer disagrees with the auditor’s findings, she has at least three options. She can challenge the assessment in tax court or she can pay the assessment and sue for a refund in district court. But before she takes either of these actions, the taxpayer can request the case be referred to the IRS Office of Appeals. The office’s mandate is to independently review an audit’s findings, to reverse any that are unwarranted and, if possible, to settle the case short of litigation.

The appeals office will not give away valid tax assessments based on specious arguments raised by ill-informed taxpayers. However, it will consider the hazards of litigation, recognizing that the IRS frequently loses nonfrivolous cases that make it to court.

I don’t know any qualified taxpayer representatives who believe that the IRS appeals process is unfairly stacked against taxpayers, even though it is run internally. In fact, it has been my experience, and that of my colleagues, that IRS auditors are eager to avoid sending shaky tax assessments to Appeals, where they are likely to be reversed. On more than one occasion, auditors and their supervisors have simply backed down when we told them to write up their findings and send them to Appeals for consideration.

It is important to note that the appeals process is part of the IRS’ determination and collection function. It does not exist as a punitive arm of the agency. That is what criminal prosecutions are for. The SEC seems to lack such clarity in its approach to administrative proceedings, which are civil cases. Like the IRS, when the SEC believes an individual or organization’s behavior rises to the level of a crime, it can refer the matter to the Justice Department, where any prosecution must establish guilt beyond a reasonable doubt.

SEC civil enforcement actions have a lesser standard of proof, but still seek to serve the aims of punishment and deterrence. That puts a premium on the process’ perceived fairness. If the SEC is going to maintain its own in-house judges, it should be up to defendants to decide whether to use them.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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