The SEC disclosed that a number of years ago, an internal control failure allowed its staff to breach a supposed robust wall intended to segregate its enforcement and adjudicatory functions. For an unspecified period of time, certain databases were not configured in a way that would restrict access by enforcement staff to memos drafted by adjudication staff.
When this failure was discovered, the commission began working to fix the control gap. The regulator has also started an internal review to better assess the impact of the control deficiency.
In particular, the SEC prioritized the review and made public its findings of two adjudicatory matters currently in litigation in federal court: SEC v. Cochran and Jarkesy v. SEC. The Cochran case involves CPAs.
“In both matters, the review found that agency enforcement staff had access to certain adjudicatory memoranda, but that this access did not impact the actions taken by the staff investigating and prosecuting the cases or the Commission’s decision-making in the matters,” the SEC said in an April 5, 2022, statement.
“We deeply regret that the Commission’s systems lacked sufficient safeguards surrounding access to Adjudication memoranda,” the SEC said, adding that it takes this lapse very seriously and is working hard to make sure it never recurs.
The internal review is ongoing.
Observers said this is serious and leaves a black mark on the agency, which oversees a huge capital market that is worth nearly $ 100 trillion.
“This is certainly embarrassing, particularly because the deficiency touches on the fairness of the core functions of enforcement and adjudication,” former SEC general counsel Daniel Goelzer said. “The commission does, however, deserve credit for providing such a detailed and candid description of the problem.”
Some were more critical and asked who at the SEC is responsible for ensuring that the control is working, and wanted to know who, if any, was held accountable.
“We decline to comment beyond the statement,” said Aisha Johnson, director of SEC media relations. However, she pointed to a passage in the statement that says that when this problem was discovered, SEC Chair Gary Gensler immediately directed the staff to fix it, including enhanced access controls. Moreover, he initiated the review.
Enforcement and Adjudication in One Place
As capital markets regulator and enforcement agency, the SEC has the power to both investigate wrongdoing and to institute an administrative proceeding to determine whether there was a violation of the securities laws. The commission may preside over such a proceeding and issue a decision.
Under the Administrative Procedure Act (APA), regulators separate the two functions among the agency staff. This means that agency employees who are investigating or prosecuting an adjudicatory matter before the commission generally should not participate in the commission’s decision-making of that matter.
The commission explained that a party to an administrative proceeding files motions and briefs with the Office of the Secretary and does not communicate directly with the commission about the proceeding.
By contrast, adjudication staff submit internal memos to the commission to aid with decision-making. The SEC explained that when the databases were improperly configured, administrative support personnel from enforcement accessed adjudication memos. They in turn emailed the memos to other staff who in many cases uploaded the files into enforcement databases.
Critics of SEC’s Enforcement Practices
This mistake is now giving ammunition to those who have been critical of the SEC’s enforcement practices and processes.
“Using the administrative process to adjudicate enforcement actions has long been criticized as an inappropriate merger of the prosecutor function with the adjudicator function which at best presented an appearance of unfairness and at worst is unfair,” said Thomas Gorman, a partner with Dorsey & Whitney LLP.
“The SEC, among other agencies however, has long maintained that there is complete separation so that in reality the process is fair. Perhaps,” said Gorman, who previously served as a senior enforcement attorney at the commission. “But now the SEC has issued a report which admits that appearance equals reality, the separation is a myth because it was not maintained. Yet at the agency claims that it conducted an inquiry which concluded, in fact, fairness was maintained.”
In the meantime, the U.S. Chamber of Commerce, which has long sought reforms on all aspects of the SEC’s enforcement, said it is time for change. Among other things, the business group sought to put a limit on the use of in-house administrative judges in its enforcement actions. Businesses say that the agency has unfair advantages when administrative proceedings are used instead of federal courts.
The SEC should not act as a prosecutor but consider different aspects of the forums where cases are brought by adhering to its “multiple statutory mandates” to protect investors, promote capital formation, and ensure fair and orderly markets. And in 2015, the business group issued a 67-page report with recommendations to improve the commission’s enforcement.
“Enforcement is an important tool for efficient markets, however, meaningful due process is the cornerstone of a fair adjudicatory system,” Tom Quaadman, an executive vice president with the U.S. Chamber, said on April 6. “It is long overdue for Congress to pass a right of removal bill to give defendants an opportunity to have their case heard in a Federal District Court.”
Dorsey’s Gorman added that the SEC cannot have it both ways. Clearly separating prosecution and adjudicative functions ensure fairness.
“This is beyond credibility,” Gorman added. “It demands reform.”
Findings of Two Cases
The SEC said that both incidents occurred in November 2017. This is when Jay Clayton was running the agency.
On Cochran, the SEC said that an administrative staff in enforcement sent one adjudication memo to other administrative personnel to be uploaded to the enforcement database. But the internal review showed that the adjudication memo was emailed a day after the commission issued the order discussed in the memorandum.
“Thus, the Enforcement staff responsible for investigating and prosecuting the matter would have had no opportunity to view or use the information in the memorandum prior to the order’s issuance,” the SEC stated. “Further, interviews with Enforcement staff show no evidence that any of the individuals assigned to investigate and prosecute the Cochran matter accessed the Adjudication memorandum.”
On Jarkesy, the SEC said that an enforcement staff member sent 10 adjudication memos. Then, the personnel uploaded the memos in many instances to the enforcement database.
“The review team’s interviews revealed no evidence that any of the individuals assigned to investigate and prosecute the Jarkesy matter accessed any of these Adjudication memoranda,” the SEC said. “The timeline of relevant events further confirms these findings.”
This article originally appeared in the April 7, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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