As the season changes to fall, and baseball playoffs and football dominate sports headlines, the home field advantage has proven important once again. But in the regulatory litigation game, it appears that even a home field advantage cannot help the Securities and Exchange Commission consistently win its enforcement trials in administrative proceedings. The SEC clearly expected to do better when it announced it would be bringing more cases in its administrative forum as opposed to district court. But in the last 25 months, the SEC has lost a number of high-profile administrative cases, notwithstanding the fact that the SEC has distinct advantages over respondents in these proceedings, such as less comprehensive discovery rules, no juries, and relaxed evidentiary requirements. Despite all these advantages, the SEC has struggled to win consistently in the administrative forum.
An examination of recent losses appears to signal the reason for this trend: the SEC may be overreaching or overcharging its cases because it has failed to appreciate the quantum of proof required to prevail, particularly as to proving the difficult element of scienter, or intent. It also appears that the SEC has failed to take into account that not all administrative law judges will share the SEC’s presumption that evidence and inferences drawn therefrom should lead to the most nefarious conclusion, particularly when other plausible theories exist. Practitioners familiar with the sometimes one-sided, cynical views expressed by the Enforcement Division Staff during investigations will understand why such views could result in overreaching in the charging of cases. Generally, the SEC’s evidentiary deficiencies come in one of two forms: a failure to prove scienter or a failure to present sufficient facts to prove its theory of the case and to counter alternative theories consistent with innocence. Although the SEC still wins a large percentage of its administrative proceedings, a notable trend has recently emerged in which the SEC has failed to present sufficient evidence to prevail.
Failure to Prove Scienter
For many securities law violations, liability turns on whether the SEC can prove that the respondent had scienter, or the intent to defraud, deceive, or manipulate. Scienter can be (and often is) established by circumstantial evidence.[1] However, recent SEC losses have shown that the SEC has failed to develop and present persuasive evidence of scienter to support its theory. For example, in In the Matter of Barbara Duka, the SEC accused respondent Duka of committing fraud to generate business for her employer, Standard and Poor’s Rating Service, by changing ratings calculation methodologies without clear disclosure. Although the ALJ found Duka was negligent on certain aspects of the disclosure, the ALJ concluded that “there [was] no evidence that Duka acted with intent,” and that the evidence actually showed that Duka had analytical justifications and supervisory approval for disclosure changes, negating the SEC’s intent argument.[2] The ALJ further concluded that the SEC’s scienter argument “ignores the context” of the record that showed Duka actually intended to produce analytically sound ratings.[3]
Similarly, in In the Matter of Lynn Tilton, the SEC accused Private Equity Fund manager Lynn Tilton of fraud and other misconduct related to disclosures about her fund’s investments. In dismissing the case, the ALJ found that the SEC had failed to prove scienter.[4] Even though the evidence showed that Tilton’s disclosures were unclear, the ALJ did not equate the lack of clarity with intentional fraud, in part because there was no power asymmetry between Tilton and her investors and because she disclosed all of the relevant information, albeit in an unusual manner.[5] Here, the SEC’s pessimistic view that the atypical nature of Tilton’s disclosure alone demonstrated fraudulent intent was not enough to meet its burden. Even outside of the fraud space, the SEC has had trouble proving the requisite mental state to establish liability. In In the Matter of Equity Trust Company, an ALJ dismissed proceedings against a custodian for Self-Directed Individual Retirement Accounts because the SEC failed to prove that ETC knew or should have known that some of the investments in its accounts had been promoted by two individuals who would later be convicted of fraud.[6] On appellate review, the full Commission upheld the decision, because the Enforcement Division “did not establish by a preponderance of the evidence that ETC knew or should have known that its conduct would contribute” to fraud.[7] The ALJ’s decision highlighted how both promoters appeared to be legitimate businessmen throughout most of their interactions with ETC, and ETC conducted sufficient due diligence on each individual upon signs of financial difficulty. The ALJ also rejected the Enforcement Division’s conclusions that effectively equated signs of financial difficulty and bad communication habits with indications of fraud. Thus, the Enforcement Division’s conclusory argument that ETC knew about these promoters’ financial difficulties failed to persuade both the ALJ and the reviewing Commission that ETC knew it was furthering fraud.
These decisions highlight the SEC’s failure to develop evidence of scienter in its investigations. The SEC appears to be relying too heavily on individual pieces of circumstantial evidence to prove scienter that tell an incomplete story or are negated by other equally plausible and persuasive evidence. These cases suggest that the SEC’s perception of the difficulty of proving intent is miscalibrated, and that it needs to build stronger evidence to prevail. As these cases show, the SEC’s circumstantial evidence is not sufficient to clear the preponderance hurdle, particularly when countered by respondents’ explanations for their conduct. But the lack of persuasive scienter evidence is only one of the problems that have doomed recent SEC trials. The SEC also appears to be failing to appreciate that the evidence, when viewed in context, can demonstrate a completely different, plausible, and innocent story that will be accepted by the fact-finder.
Alternative Versions of Events
The SEC has also struggled recently to persuade ALJs that its theory of the case is supported by the evidence because the SEC’s proof fails to negate other plausible theories consistent with innocence. For example, in In the Matter of Gregory T. Bolan, Jr., and Joseph C. Ruggieri, an insider trading case, the SEC theorized that research analyst Gregory Bolan provided tips to Joseph Ruggieri, a co-worker in the trading group at Wells Fargo, about Bolan’s unreleased ratings reports so that Ruggieri could trade and profit. In his decision dismissing the charges against Ruggieri, which the Commission upheld on review, the ALJ concluded that although the SEC had met its burden to prove Bolan tipped Ruggieri in four of the six alleged instances, it had not proven that Bolan exchanged the tips for a personal benefit. The ALJ rejected the SEC’s argument that Bolan tipped so he could develop personal and professional relationships. Rather, the evidence showed that Bolan already had a positive reputation at Wells Fargo before he began tipping and that Ruggieri provided both personal and professional support to Bolan outside of the alleged tipping scheme, consistent with how co-workers and friends not caught up in wrongdoing would act.[8]
In another insider trading case, In the Matter of Charles L. Hill, Jr., an ALJ dismissed the SEC’s allegations that Hill obtained confidential information from corporate insiders and traded on it. The SEC alleged that Hill learned about a company’s impending merger from a mutual friend of the COO of one of the merging companies. But the ALJ found that the SEC had provided no basis to connect the tips back to company insiders and failed to show that they occurred via the alleged tipping chain, as opposed to another source, notwithstanding Hill’s unusual trading pattern.[9] Here again, the SEC appears to have been relying on speculation and inference rather than hard evidence. Similarly, in Tilton, the ALJ rejected the SEC’s theory that Tilton had misled her investors by pointing out that all relevant information was disclosed somewhere, even if it was not presented in an intuitive and explicit manner.[10] And as previously mentioned, in Duka, the ALJ concluded that the SEC’s theory was countered by other pieces of evidence inconsistent with liability, and therefore that the SEC had not met its burden of proof.[11]
These recent cases illustrate that although the SEC can rely on circumstantial evidence to prove its allegations, it must do so convincingly. In these cases, the SEC has failed to develop and present sufficient evidence of its theory to negate other plausible theories consistent with innocence. Like in the cases where it failed to establish scienter, the SEC appears to be relying too heavily on speculative inferences from circumstantial evidence and ignoring or failing to sufficiently counter other facts inconsistent with its theory. In future litigation, respondents will continue to poke holes in the SEC’s proof, particularly on scienter and alternative theories consistent with innocence, which will require the SEC to develop stronger proof if it hopes to reverse the recent trend of losses.
Takeaways
In the wake of this string of recent losses in administrative proceedings, the SEC should be re-evaluating its proof and charging decisions. When it began to shift away from filing cases in district court, it likely believed it would see more success in administrative proceedings, but that has not consistently been the case. Although the SEC is still winning many of its administrative cases, its recent losses reflect a failure to evaluate the strength of its proof, particularly in cases where scienter evidence is thin, or overall evidence of alternative theories consistent with innocence is equally strong. If the SEC does not trim charges or exercise its discretion and decline to bring some of these cases, respondents will continue to exploit these evidentiary failures, as recent success has shown. This trend could also encourage respondents who think the government’s case is thin to litigate rather than settle. Only time will tell if these trends will continue, but for now, the message is clear: if the SEC wants to regain the home field advantage, it needs to take the field with more evidence to support its theories.
ENDNOTES
[1] In the Matter of Barbara Duka, Initial Decision Release No. 1030, 52 (ALJ Aug 29, 2017).
[2] Id. at 54.
[3] Id. at 62.
[4] In the Matter of Lynn Tilton, et. al, Initial Decision Release No. 1182, 56 (ALJ Sept. 27, 2017).
[5] Id. at 51–56.
[6] In the Matter of Equity Trust Company, Initial Decision Release No. 1030, 32 (ALJ June 27, 2016).
[7] In the Matter of Equity Trust Company, Securities Act Release No. 10420, 9 (Sept. 28, 2017).
[8] In the Matter of Gregory T. Bolan, Jr., and Joseph C. Ruggieri, Initial Decision Release No. 877, 39–49 (ALJ September 14, 2015); In the Matter of Joseph C. Ruggieri, Securities Act Release No. 10389, 3–5 (July 13, 2017).
[9] In the Matter of Charles L. Hill, Jr., Initial Decision Release No. 1123, 23 (ALJ April 18, 2017).
[10] Tilton, at 51–56.
[11] Supra note 2.
This post comes to us from King & Spalding LLP. It is based on the firm’s memorandum, “Home Field Advantage Fades for SEC Litigators,” dated November 2, 2017, and available here. A version of the post appeared in the New York Law Journal and is reprinted with permission, © 2017 ALM Media Properties, LLC. All rights reserved.