Due Process, Fairness: SEC Administrative Enforcement Actions

The Commission’s increased use of administrative proceedings as the venue of choice for enforcement actions sparked a series of suits challenging the practice. The challenges have been largely unsuccessful, although they may result in the Supreme Court determining whether SEC administrative law judges must be appointed in accord with the requirements of the Constitution’s Appointments Clause. Raymond J. Lucia Cos. Inc. v. SEC, No. 17-130 (petition for certiorari raising question in view of split in circuits). Yet the key question raised by the suits challenging the Commission’s venue choices remains. The opinions in SEC v. Lorenzo, No. 15-1202 (D.C. Cir. Sept. 29, 2017) do not resolve the questions, but they clearly illustrate the issues.

Factual background

Frank Lorenzo became a director of investment banking firm Charles Vista, LLC in February 2009. The firm’s largest investment banking client was start-up W2Energy Holdings, Inc. That firm claimed to have developed a “gasification” technology which could generate electricity by converting sold waste to gas. The firm’s business depended largely on the success of the technology – if it failed the balance sheet would collapse.

The technology failed. In September 2009 the firm sought to raise about $15 million through the sale of convertible debentures to escape financial ruin. Charles Vista was the exclusive placement agency. The firm’s most recent Commission filing stated that W2E’s intangibles were worth just over $10 million as of the end of 2008. A private placement memorandum for the offering did not mention any devaluation of the firm’s assets.

The valuations changed following an audit in October 2009. After the audit W2E amended its earlier filing, reporting an “impairment” of the firm’s intangible assets tied to the technology. The gasification technology value dropped to zero. The firm reported total assets of $370,552. A Form 10-Q as of June 30, 2009 reported total assets of just over $660,000.

Mr. Lorenzo emailed two potential investors “several key point” about W2E’s pending debenture offering. The emails failed to mention the devaluation of the firm’s assets. To the contrary they told investors that there were “3 layers of protection,” noting that W2E had over $10 million in confirmed assets, purchase orders and LOI’s for over $43 million in orders and the that the company had agreed to raise additional sums to repay the debenture holders if necessary. One of the messages stated it had been sent at the request of Gregg Lorenzo, the owner of the firm (no relation to Respondent).

The Commission issued an Order charging Mr. Lorenzo, Gregg Lorenzo and Charles Vista with fraud in violation of Securities Act Section 17(a)(1) and Exchange Act Section 10(b). The firm and its owner settled.

Respondent Lorenzo proceeding to hearing before an ALJ. The only witness called at the hearing was Frank Lorenzo. Mr. Lorenzo testified that he sent the emails at the behest of his boss by cutting and pasting – he did not write them. The Division did not call the owner of the firm to testify. No other testimony was presented at the hearing.

The Initial Decision found that that Mr. Lorenzo did not read the text of the emails. The findings also stated that Mr. Lorenzo had sent the emails “without thinking.” Nevertheless, the ALJ concluded that Mr. Lorenzo had acted willfully with the intent to deceive, manipulate, or defraud in violation of each statute. A cease and desist order was entered, a $15,000 penalty imposed and a life-time bar from the business imposed.

On appeal the Commission affirmed. In its opinion the agency concluded that Mr. Lorenzo was responsible for the emails and their content. In a footnote the agency stated that it need not accept the findings of the ALJ.

Circuit court opinions

On a Petition for Review, the D.C. Circuit largely affirmed the determination of the Commission in a 2-1 decision, although it was remanded for reconsideration of the sanctions. The majority opinion, written by Circuit Judge Srinvasan and joined by Judge Griffith, began with an extensive review of the statements in the emails. It concluded that the Commission’s findings that each was false and misleading and that Respondent acted with scienter were supported by substantial evidence.

Nevertheless, the majority concluded that the Commission’s determination had to be remanded to the agency because Mr. Lorenzo had not violated Rule 10b-5(b) as charged in view of the Supreme Court’s determination in Janus Capital Corp., Inc. v. First Derivative Traders, 564 U.S. 135 (2011). There the Court held that only the “maker” of the statement could be held primarily liable under Rule 10bb-5(b). In this case “Lorenzo did not ‘make’ the false statements at issue for purposes of Rule 10b-5(b) because Lorenzo’s boss, and not Lorenzo himself, retained ‘ultimate authority’ over the statements,” according to the court.

Despite this determination the majority went on to conclude that Mr. Lorenzo’s conduct violated Section 10(b) and rule 10b-5 because the false statements contravened the other subsections of the rule based on a theory of scheme liability: “Although Lorenzo does not qualify as the ‘maker’ of those statements under Janus . . . his own active ‘role in . . . producing and sending the emails constituted employing a deceptive ‘device,’ ‘act’ or ‘artifice to defraud’ for purposes of liability under Section 10(b), Rule 10b-5(a) and (c), and Section 17(a)(1),” quoting the Commission’s opinion. In reaching this conclusion the court rejected Respondent’s claim that it was undermined the distinction between primary and secondary liability on which Janus is based. Since the penalty determination could have been impacted by the Commission’s incorrect determination on liability however, the sanctions were vacated and the action was remanded to the SEC for further consideration.

Judge Kavanaugh dissented. While the Judge agreed with the determination by the majority on Janus, Judge Kavanaugh dissented from what he viewed as the rewrite of the record by the Commission and accepted by the majority stating: “The good news is that the majority opinion vacates the lifetime suspension. The bad news is that the majority opinion – invoking a standard of deference that, as applied here, seems akin to a standard of ‘hold your nose to avoid the stink’—upholds much of the SEC’s decision on liability. I would vacate the SEC’s conclusions as to both sanctions and liability.”

Judge Kavenaugh’s conclusion is based on three key points. First, although the factual findings by the ALJ were very favorable to Mr. Lorenzo, the “legal conclusion [of the ALJ] do not square up.” If Mr. Lorenzo did not draft the emails, did not think about their contents and only sent them at the behest of his boss, he did not act willfully. That means mens rea is missing. Accordingly, the “administrative law judge’s decision in this case contravenes basic due process” by making findings of violation and imposing sanctions.

Second, the Commission’s decision reflects the error of the ALJ. Noting that the agency recognized this issue, it then did a “Houdini-like move . . .[and] rewrote the administrative law judge’s factual findings to make those factual findings correspond to the legal conclusion that Lorenzo was guilty and deserving of a lifetime suspension.” Terming this approach the SEC’s “own debacle,” Judge Kavenaugh found that “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.”

Finally, the majority correctly recognized the application of Janus. In accepting the “alternative facts” of the SEC, it ignored the key principle that “When the case turns on eyewitness testimony . . . the initial decision should be given considerable weight: the ALJ was able to observe the demeanor of the witnesses and assess their credibility and veracity first hand.” (internal citation omitted). The SEC’s effort at oral argument to differentiate between a situation where the email was sent on “behalf of” Mr. Lorenzo’s boss rather than “at the request of” his boss does not present a meaningful distinction. To the contrary the argument is “absurd and an illustration of how the Commission jumped the rails in this case.”

Perhaps more importantly, the majority created a circuit split “by holding that mere misstatements, standing alone, may constitute the basis for so-called scheme liability under the securities laws . . . No other court of appeals has adopted the approach” taken here. This is because “the Supreme Court has pushed back hard against the SEC’s attempts to unilaterally rewrite” the law in this manner.

In the end the administrative adjudication “of individual disputes is usually accompanied by deferential review from the Article III Judiciary. That agency-centric process is in some tension with Article III of the Constitution, the Due Process Clause of the Fifth Amendment, and the Seventh Amendment right to a jury trial in civil cases . . . That tension is exacerbated when, as here, the agency political appointees – without hearing from witnesses – disregard an administrative law judge’s factual findings. . . I respectfully dissent.”