SEC Order Vacated For Failing To Consistently Apply Its Rule

The D.C. Circuit vacated another Commission determination last week. Again, the order was not based on the merits. Again, it was based on the failure of the agency to comply with procedural requirement.

Earlier this year the Circuit Court vacated the Commission’s proxy access Rule because the agency failed to conduct the statutorily required economic analysis. Last week a Commission order refusing to vacate a default judgment entered in an administrative proceeding was vacated. This time the agency failed to properly apply its own rules. Rapoport v. SEC, No. 11-11082 (D.C. Cir. June 19, 2012).

The Order for Proceedings in the underlying action was issued in December 2008. It named as a Respondent OOO-CentreInvest Securities or CI-Moscow, a Moscow based broker dealer which specialized in the sale of second tier Russian equities. The firm’s New York affiliate, CentreInvest, Inc. or CI-New York, and several of the employees of each company, including Dan Rapoport, were also named as Respondents.

The OIP alleges violations of Exchange Act Section 15(a) since CI-Moscow never registered as a foreign broker dealer with the SEC but is alleged to have securities in the U.S. Although Mr. Rapoport was a registered representative while working in the New York office, after his return to Moscow he was not registered or licensed to sell securities in the U.S. Nevertheless, from 2003 through November 2007 CI-Moscow and Mr. Rapoport solicited institutional investors in the U.S. to purchase and sell thinly-traded stocks of Russian companies, according to the OIP. Beyond this conclusion, there is not a single specific instance in which Mr. Rapoport or the other Respondents solicited a U.S. investor detailed in the OIP.

In December 2008 the Enforcement Division served the OIP on CI-New York and on attorneys for other U.S. Respondents. Subsequently, the Division sought an order under SEC Rule of Practice 141(a)(2)(iv) which would permit service on Mr. Rapoport through counsel. That Rule provides for service to a person in a foreign country using any method reasonably calculated to give notice. Russian authorities had refused to serve the OIP. Counsel for Mr. Rapoport appears solely to contest the Division’s request. The ALJ granted the motion and the attorney who had appeared for Mr. Rapoport withdrew. Under the ruling service was considered effective on February 5, 2009. Mr. Rapoport did not respond to the OIP, although there is no claim that he did not know about the proceeding.

On April 8, 2009 the Division moved for the entry of a default judgment against Mr. Rapoport. That motion was granted on July 31, 2009 after Mr. Rapoport failed to appear at prehearing conferences. Based on the allegations in the OIP a cease and desist order was entered and a second tier penalty was imposed. Initially it was calculated to be $550,000 but later corrected to $315,000.

In December 2009 Mr. Rapoport filed a motion under Exchange Act Rule 155(b) to vacate the default judgment. That Rule permits an ALJ or the Commission to set aside a default “for good cause shown” if three requirements are met: 1) the motion must be made in a reasonable time; 2) it must specify the reasons for failing to defend; and 3) it must set forth the proposed defenses. The ALJ denied the motion concluding it had not been filed in a reasonable time, that the proffered reasons for failing to defend were inadequate and that the record, which was the OIP, supported the fact that Mr. Rapoport had in fact solicited U.S. investors. The Commission affirmed, essentially agreeing with the ALJ on the first two points and then finding it unnecessary to reach the third.

The D.C. Circuit began its analysis by noting that agencies must apply their rules consistently. As a corollary to this point, they “may not depart from their precedent without explaining why.” If they do the Circuit Court has no choice but to remand for an explanation. Here this is precisely what has happened.

First, the Commission did not follow Rule 155(b) since it failed to consider the third prong of the test. In the Circuit Court the SEC cited a series of decisions in its brief for the proposition that this prong of the three part test need not be considered where the there are findings, as here, that the motion failed to meet the first two requirements. Finding that none of the cited cases supported the Commission’s claim, the Circuit Court requested that the point be addressed at oral argument. More cases were cited by the SEC at argument. None of the additional cases supported the Commission’s position, according to the Court. While the Circuit Court did not state that the SEC was precluded from interpreting Rule 155(b) in the manner that it did in this case, it concluded that the agency had failed to provide “a consistent interpretation of the Rule . … [and has] not justified the apparent inconsistency of its application. Although the Commission is not bound to follow its precedent, it may not depart from its precedent without offering a reasoned explanation . . . It has not provided such an explanation here.”

Second, the Commission “has failed to provide any intelligible standard to assess what constitutes a ‘reasonable” amount of time for filing a motion to set aside a default under Rule 155(b).” Here the Commission discussed a range of dates in the case and cited its prior decisions which consider different time points for commencing the time period for determining reasonableness but it failed to “set forth a principled way in which to determine on what date the “reasonable time” clock starts running.” The SEC also failed to state with any clarity how it determines what constitutes a “reasonable time.” While agencies have flexibility in interpreting their rules, the Commission “has left ‘vague and inclusive” the date that starts the ‘reasonable time clock, as well as the mount of time considered reasonable.” This it may not do.

Finally, the Court concluded that the civil penalty had not been calculated in accord with the statute. The Commission has the authority to impose a second tier penalty for each violation where it finds that the conduct was willful and involved fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement. In this case however a maximum second tier penalty was imposed for each year of the alleged scheme, not for each violation. This is not in accord with the statutory requirements since the “Commission must determine how many violations occurred and how many violations are attributable to each person, as the statute instructs.” Since the Commission failed to comply with the statute and to explain its inconsistent and vague application of its Rule, the order was vacated and the proceeding remanded.