An otherwise mundane SEC announcement on July 30, 2014 of an enforcement action charging a public company CEO and CFO with accounting fraud and internal controls violations is significant because the SEC is proceeding against the non-settling individual (the CEO) in an administrative proceeding rather than in federal court. While not unprecedented, it has been, to date, exceedingly rare for the Commission to proceed against an unregulated entity or person administratively rather than in federal court. This decision reflects the Commission’s and Enforcement Division’s recently, but frequently, stated intent to bring more administrative proceedings that previously would have been brought in federal court, now that the Commission has expanded remedies under Dodd-Frank Act. The decision also raises significant due process issues.
The action itself charges Marc Sherman and Edward Cummings, CEO and former CFO, respectively, of QSGI Inc., a Florida-based computer equipment company, with violation of the antifraud and other provisions of the Securities Exchange Act of 1934 and the Sarbanes-Oxley Act of 2002. According to the Commission’s press release, Sherman and Cummings claimed they had disclosed all significant deficiencies in internal controls over financial reporting to the company’s independent auditors, but in fact did not disclose or direct anyone else to disclose ongoing inventory and accounts receivable issues or improper acceleration of recognition and the resulting falsification of QSGI’s books and records. The Commission also alleges that the executives signed SEC filings and Sarbanes-Oxley certifications that were rendered false and misleading due to the above issues. Cummings entered into an administrative settlement with the SEC, agreeing to a cease and desist order, a $23,000 civil penalty, a 5-year officer and director bar, and a 5-year bar on appearing or practicing before the Commission as an accountant. Sherman did not settle, and will instead litigate against the Division of Enforcement in an administrative proceeding.
As mentioned, the Commission’s decision to have this matter litigated administratively rather than in federal court is noteworthy. While the Commission typically brings cases against regulated entities and individuals (such as broker-dealers, investment companies and advisers, and accountants) administratively, it usually brings cases against unregulated entities and individuals in federal court, due in large part to the remedies it can obtain in federal court. The Dodd-Frank Act, however, expanded the range of remedies the Commission can obtain in its administrative forum, and Commission and senior Enforcement Division officials have recently emphasized that more cases, both settled and non-settled, will be brought administratively.
This new approach raises a number of serious due process issues. Under the Commission’s Rules of Practice, an administrative proceeding is conducted on a “rocket docket” basis, with only about 4-5 months from the institution of the proceeding to the trial. Thus, while the Commission’s staff is thoroughly familiar with the typically voluminous record from having investigated the matter, often for a number of years, the defendant’s counsel is given precious little time to do the same. Further, while the Commission staff is able to collect as many documents and take as many depositions as it wants during the investigation, the Rules give defense counsel only very limited leeway to take discovery. Thus, as a practical matter, defense counsel’s “discovery” is limited essentially to the investigative record that the staff chose to compile. Finally, unlike in federal court, where a defendant has a right to a jury trial before a civil penalty (often substantial) may be imposed, administrative proceedings are conducted before and decided in the first instance by an administrative law judge employed by the SEC itself, with no right to a jury. For these reasons, many securities enforcement practitioners have been calling for the Commission to revise its Rules of Practice to address these concerns.
While federal courts have long approved the general concept and use of administrative proceedings, the status of the SEC’s use of an administrative penalty proceeding against an unregulated person is unclear, simply because there have not been any such proceedings to speak of. In SEC v. Gupta, 796 F. Supp. 2d 503 (S.D.N.Y. 2011), the SEC’s first post Dodd-Frank attempt to bring an administrative penalty proceeding, Judge Jed Rakoff held that a defendant accused of insider trading could sue the SEC for violation of the Equal Protection Clause of the U.S. Constitution, where that defendant was the only one of 28 similarly situated individuals to be sued administratively rather than in federal court. In the course of his order, Judge Rakoff noted the Commission’s “seeming exercise in forum-shopping” in deciding to proceed on its “home turf” and the defendant’s allegation that the Commission’s choice of forum was designed “to gain an unfair advantage by depriving [him] of the protections he would have had if the case were brought in federal court, including full discovery, application of the federal rules of evidence, the ability to assert third-party claims for indemnification and contribution, the ability to bring counterclaims against the SEC, and, most importantly, a right to a jury trial ….” Notably, the SEC terminated its administrative proceeding in the wake of Judge Rakoff’s order. It is reasonable to expect that similarly situated defendants – unregulated entities and individuals facing civil penalties in administrative proceedings – will raise the same issues, initially before the Commission and then, if necessary, in federal court.