Taming a Strange New Beast: Securities Regulators Take on Digital Currency

by Jack Falvey and Brendan Radke

Legal Analysis

The emergence of blockchain technology led in recent years to a surge in sales and trading of digital currencies – including well-known currencies like Bitcoin as well as hundreds of offerings of so-called digital “tokens” issued for use on individual websites. In 2017 and 2018 alone, more than $20 billion was raised through “initial coin offerings,” in which technology companies, typically startups, sold tokens for use on their web- based platforms. Federal and state regulators have scrambled to understand the technologies behind this new class of assets, including whether and by whom they should be regulated. The federal Securities and Exchange Commission (“SEC”) has been at the forefront in these efforts. In April 2019, after two years of proceeding in fits and starts, it recently issued guidance that finally seeks to set firm ground rules for issuers. This article reviews the SEC’s and other regulatory and enforcement responses to date, and the landscape going forward.

Digital Currency Basics

What is Blockchain Technology?

Digital currency is built on blockchain technology, often described as a “distributed ledger” digital technology. A blockchain is a form of online database that operates upon a peer-to-peer network of computers. Those networks may be decentralized, meaning that transactions upon the ledger are independently verified by individual computers (called nodes) accessing the network rather than being routed through a proprietary central data system. In a blockchain transaction, a user requests a transaction; that request is broadcast to the network of nodes; and those nodes verify the transaction and the user’s status through a known algorithm. Once verified, the transaction is combined with others and memorialized in entries called “blocks” of data for the ledger. Finally, the new block is cryptographically (i.e., securely) linked to the previous block after validation by the network, and added to the existing blockchain. The resulting blockchain is immutable, and the new block of data then is available to the next user on the chain. Major financial and technology firms have embraced and invested heavily in blockchain: it is widely expected to cut costs and processing times sharply in fields such as financial services and supply chains.

What is Digital Currency?

The best-known application of blockchain is Bitcoin, the digital currency created over a decade ago whose market value rose as high as $20,000 per digital coin at its peak in 2017 before falling sharply since. Bitcoin and its competitors (such as Ether and Litecoin) are sometimes referred to as “cryptocurrencies” – digital assets that can be used as exchange media in online commercial transactions with parties. The novelty of cryptocurrency is that it requires no third-party bank or other agency to clear transactions: the transfer occurs directly between two parties and is permanently memorialized on the blockchain. Cryptocurrencies are now exchange-traded and widely distributed, with growing acceptance among mainstream businesses.

Digital currency also includes so-called digital “tokens,” a term used because conceptually, they are said to operate like arcade tokens – they function like money on the host’s website. A digital token typically works on the framework of an existing blockchain (say, on the Ethereum blockchain) rather than a blockchain unique to the issuing company, and is generally capable of use only upon the issuing company’s application. Hundreds of companies have issued tokens as a feature of their applications – typically to attract users to the site and seek to build loyalty in a wide range of uses.

What is an Initial Coin Offering?

Issuers have offered tokens for sale in a process referred to as an “initial coin offering” or “ICO.” In advance of token sales, offerors have issued an offering document, usually referred to as a “white paper,” that generally described the company, its plans for the token sales and their intended use, and, to varying extents, how the issuer plans to use the proceeds from the token sales. Until recently, the offerors usually didn’t conceive of the tokens as securities, in part because the tokens had a designated utility on the offeror’s web-based platform, and in part because they were referred to as “tokens” or “coins.” The offering materials typically had nowhere near the required content of a registration statement that would need to have been filed with the SEC in an offering of securities.

Despite the often scant offering information, ICOs in the last several years attracted a community of purchasers who collected and traded the tokens. Issuers sold tokens in limited supply; and third parties launched unregulated, online trading exchanges through which tokens could be traded and their value bid higher than the issuing price. The result was a considerable amount of speculation on their value.

The market for digital tokens exploded in 2017 and early 2018. While available data is inexact, hundreds of ICOs are thought to have raised roughly $20 billion in those two years alone. Total funds raised through ICOs increased from 2017 to 2018, while at the same time the average offering size was halved, from an average of $24 million in 2017 to $12 million in 2018. ICOs were launched around the globe. Initially, China had the largest presence in this market (until it essentially outlawed them in late 2017). The United States accounted for most of the market in 2017, and the United Kingdom, Singapore, and Eastern European countries also became popular forums.[1] Amounts raised have dropped sharply since early 2018, with an estimated $100 million having been raised in the first several months of 2019.[2]

The SEC Takes on Digital Currency

The success of many ICOs and the subsequent climb in many tokens’ trading value commanded the attention of state and federal regulators in 2016 and 2017. The SEC saw a need to balance “support [of] innovation and the application of beneficial technologies” with concerns that issuers were essentially raising capital in defiance of securities laws.[3]

The DAO Report and Munchee Order

In mid-2017 – after billions had already been raised through ICOs – the SEC began a series of incremental steps to delineate its regulatory and enforcement reach.[4] In the so-called DAO Report issued in July 2017 (involving a virtual organization known as “the DAO”), the SEC announced that digital currencies were securities if they met the test for an “investment contract,” an enumerated type of security under the federal securities laws.[5] The SEC applied the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. that defined an investment contract – essentially, any contract that involves an investment of money in a common enterprise with a reasonable expectation of profits from the efforts of others.[6] The DAO Report found the digital token at issue to be a security, but under a relatively unique set of facts; the DAO currency carried with it voting and profit-sharing rights, which most digital currencies lack and which strongly resemble rights associated with common stock.[7]

The next SEC action of note was its December 2017 Cease and Desist Order to a token issuer called Munchee that provided more generally-applicable guidance.[8] The Munchee Order indicated that a token would likely be deemed a security if a company: primed purchasers to expect profits (e.g., by describing how a token would or could increase in value); broadly marketed tokens rather than targeting sales to users of the platform; and/or used proceeds from the token sale to further develop the platform. All of these activities suggested that the Munchee token met the key Howey factors: purchasers reasonably expected to profit from the efforts of others by holding the tokens and were investing in a common enterprise, i.e., development of the platform. The company agreed to shut down its offering.

SEC Enforcement Remedies for Failure to Register

In late 2017 and most of 2018, the SEC stepped up its public statements referring to digital currencies as securities. Top SEC officials noted that they were proceeding carefully but also that, as SEC Chairman Clayton stated in late 2017, he had “yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” The SEC had issued dozens of investigatory subpoenas to issuers in 2017, but it had commenced few actions against digital currency offerors.

In late 2018, the SEC brought and settled two enforcement actions spelling out, for the first time, the remedies that it would demand where it determined that an ICO amounted to an unregistered securities offering. In each case it: imposed penalties of $250,000; required implementation of a public claims process whereby investors who purchased the tokens in the initial offering would notified of their rights to sue and a mechanism by which they could recover the consideration paid for the tokens plus any amounts to which they are entitled under Section 12(a) of the Securities Act; required registration of the tokens as securities; and required ongoing compliance with its public reporting requirements.[9]

The SEC’s settlement in February 2019 settlement with Gladius Network was also significant, since it signaled the somewhat softer line it would take in a scenario where the issuer self-reported and cooperated. As with the prior settlements, the company agreed to register its tokens and establish a notice and claims process, but avoided any monetary penalty due to its self-report, cooperation, and remedial steps.[10]

The April 2019 Investment Contract Framework and First No-Action Letter

Finally, and most recently, the SEC announced on April 3, 2019 two significant actions. First, it issued a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (“Framework”) that, though not a rule or regulation, provides a roadmap for how the SEC intends to apply Howey.[11] It states essentially that two factors drive its analysis: whether the purchaser would be relying on managerial efforts of others, and whether he or she anticipated profits from those efforts. Key factual considerations are: the state of development of the issuer’s network; whether company management continued to oversee it; and whether the issuer had taken any steps to enhance the token’s market price including its tradability on secondary markets. A token has a better chance of avoiding classification as a security if (1) the token is not designed for use as an investment, (2) the network on which it is utilized is complete prior to the sale, and (3) there is little, if any, opportunity for price appreciation.

On the same date, the SEC’s Corporation Finance Division issued is first “no-action letter” to a token issuer, allowing it to proceed with an unregistered token issuance on the issuer’s proposed terms, which aligned with the Framework factors.[12] The requestor, TurnKey Jet, Inc. proposed to issue a token usable to purchase private jet services through its network. The SEC stated it would take no action against the company if the unregistered sale adhered to the proposed terms. Among the terms prescribed in the letter were that the tokens were usable immediately upon sale, TurnKey Jet would not use sale proceeds to develop its network, the tokens’ value was fixed at a dollar, they would be repurchased only at a discount and could not be used or transferred elsewhere, and that marketing would focus solely on the tokens’ functionality.

The Framework and no-action letter together provide a guide to whether and how an offeror may avoid having its token classified as a security and being subject to SEC registration and regulation. Alternatively, token issuers whose tokens will be deemed securities might be able to structure more restricted offerings so as to comply with any of several different exemptions: Regulation D, applicable to private offerings to qualified investors; Regulation S, a safe harbor applicable to offerings occurring solely overseas; or Regulation A+, providing a streamlined process for SEC registration, disclosure, and review of certain offerings capped at $50 million, with other restrictions.[13] Finally, more established digital-token offerors may just bite the bullet and pursue a traditional securities offering. For example, in April 2019, blockchain software provider Blockstack filed with the SEC a securities registration statement for a $50 million token sale pursuant to Regulation A+.

Other Federal and State Law Enforcement

While the SEC has been the most visible actor, a range of government agencies have sought to regulate or launch enforcement matters in connection with ICO activity. They include:

U.S. Department of Justice: The Department of Justice has actively investigated and prosecuted a number of high-profile cases against individuals for fraud and money laundering based on deliberate and materially misleading statements in connection with ICOs and other token sales. Recent cases include United States v. Zaslavskiy, No. 17-CR-647 (E.D.N.Y.) (filed October 2017), the first federal criminal action against an ICO issuer; United States v. Rice, No. 3:18-CR-587-K (N.D. Tex.) (filed November 2018); and United States v. Crater, No. 19-CR-10063 (D. Mass.) (filed February 2019).

U.S. Commodity Futures Trading Commission: The Commodity Futures Trading Commission (“CFTC”) views certain digital currencies as commodities and has pursued enforcement actions and published extensive guidance in the area.[14] It deems virtual currencies to be commodities under the Commodity Exchange Act,[15] which prohibits fraud in the sale or trading of commodities and derivative instruments based upon commodities. Recently, two federal courts upheld the CFTC’s position that digital currencies are commodities.[16]

Financial Crimes Enforcement Network: FinCen, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network, has issued guidance concerning digital currency since 2013. In 2018, it announced that it too intends to apply its regulatory requirements to digital currencies, and on May 9, 2019, it issued extensive guidance describing how crypto businesses may be considered “money transmitters” and thus subject to the restrictions of the Bank Secrecy Act and other laws.[17]

State regulators and Cross Border Actions: Securities and financial services regulators in Texas, Massachusetts, and New York all have brought recent enforcement matters. Cross-border, the North American Securities Administrators Association, an organization of state, provincial, and territorial securities regulators, announced a coordinated series of state and provincial enforcement actions in the United States and Canada.[18]

Conclusion

The SEC has proceeded cautiously in its early years of addressing digital currency offerings. Ultimately, though, its enforcement matters in 2017 and 2018, capped by its April 2019 guidance, have sought to thwart the use of ICOs to raise operating capital without complying with securities laws. Going forward, those involved in digital currency offerings will need to navigate carefully the federal securities laws, other federal and state laws, and the efforts of myriad enforcement authorities who will be closely watching the digital currency arena for currency, antifraud, and other regulatory compliance.

 

Jack Falvey is a partner at Goodwin in Boston, where he represents companies and individuals in securities-related and other white collar matters as well as a range of complex civil litigation. He has represented digital currency issuers in matters before the SEC and other enforcement agencies. He was a federal prosecutor in Boston from 1994 to 2000. 

Brendan Radke is a senior associate at Goodwin in San Francisco. His practice includes a variety of work within the cryptocurrency and blockchain sectors, as well as commercial, intellectual property, securities, and white collar litigation.

 

[1] Daniele Pozzi, ICO Market 2018 vs 2017: Trends, Capitalization, Localization, Industries, Success Rate, Cointelegraph (Jan. 5, 2019), https://cointelegraph.com/news/ico-market-2018-vs-2017-trends-capitalization-localization-industries-success-rate.

[2] #Crypto Utopia, Autonomous NEXT, https://next.autonomous.com/crypto-utopia (last visited May 16, 2019); Paul Vigna, Bitcoin Is in the Dumps, Spreading Gloom Over Crypto World, WSJ (Mar. 19, 2019), https://www.wsj.com/articles/bitcoin-is-in-the-dumps-spreading-gloom-over-crypto-world-11552927208?mod=searchresults&page=1&pos=5.

[3] Public Statement on Digital Asset Securities Issuance and Trading (Nov. 16, 2018), https://www.sec.gov/news/public-statement/digital-asset-securities-issuance-and-trading

[4] William Hinman, Director, Division of Corporation Finance, Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.

[5] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf. (“The DAO Report”).

[6] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946) (the definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”);Tcherepnin v. Knight, 389 U.S. 332, 336 (1967) (“form should be disregarded for substance”); United Hous. Found., Inc. v. Forman, 421 U.S. 837, 849 (1975) (the emphasis should be “on economic realities underlying a transaction, and not on the name appended thereto.”); see 15 USC § 77(b)(a)(1) , Section 2(a)(1) of the Securities Act of 1933 and 15 U.S.C. § 78c(a)(10), Section 3(a)(10) of the Securities Exchange Act of 1934.

[7] The DAO Report, at 1, 3.

[8] Public Statement, SEC Statement Urging Caution Around Celebrity Backed ICOs (Nov. 1, 2017), https://www.sec.gov/news/public-statement/statement-potentially-unlawful-promotion-icos; In the Matter of Munchee Inc., Securities Act Release No. 10445 (Dec. 11, 2017), https://www.sec.gov/litigation/admin/2017/33-10445.pdf.

[9] Press Release, SEC, Two ICO Issuers Settle SEC Registration Charges, Agree to Register Tokens as Securities (Nov. 16, 2018) https://www.sec.gov/news/press-release/2018-264

[10] Gladius Network, LLC, Securities Act Release No. 10608 (Feb. 20, 2019), https://www.sec.gov/litigation/admin/2019/33-10608.pdf.

[11] Statement on Framework for “Investment Contract Analysis of Digital Assets” (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

[12] TurnKey Jet, Inc., SEC No-Action Letter (Apr. 3, 2019), https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm.

[13] See 17 C.F.R §§ 230.500 et seq.; 17 C.F.R. §§ 230.901 et seq.; 17 C.F.R. §§ 230.251 et seq.

[14] The SEC largely concedes that the cryptocurrencies Bitcoin and Ether aren’t securities, in light of their decentralized and operational networks, but this will remain a fact-specific inquiry. The Director of its Division of Corporate Finance observed in June 2018: “[W]hen I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise… Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value… Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.” W. Hinman, Remarks at the Yahoo Finance All Markets Summit, https://www.sec.gov/news/speech/speech-hinman-061418; see also https://www.cftc.gov/Bitcoin/index.htm.

[15] See 7 U.S.C. § 1a(9) (commodities include “all other goods and articles … and all services, rights and interests … in which contracts for future delivery are presently or in the future dealt in”); In the Matter of Coinflip, Inc., d/b/a Derivabit, CFTC No. 15-29 (Sept. 17, 2015), https://www.cftc.gov/sites/default/files/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf; CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018); CFTC v. My Big Coin Pay, Inc., 334 F. Supp. 3d 492 (D. Mass. 2018);

[16] McDonnell, 287 F. Supp. 3d at 228 and My Big Coin Pay, Inc., 334 F. Supp. 3d at 498.

[17] U.S. Dep’t of Treas., Letter to The Honorable Ron Wyden (Feb. 13, 2018), https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-center.pdf; Kenneth A. Blanco, Director, FinCEN, Prepared Remarks at the 2018 Chicago-Kent Block (Legal) Tech Conference (Aug. 9, 2018), https://www.fincen.gov/news/speeches/prepared-remarks-fincen-director-kenneth-blanco-delivered-2018-chicago-kent-block; Kenneth A. Blanco, Director, FinCEN, Prepared Remarks at the 11th Annual Las Vegas Anti-Money Laundering Conference and Expo (Aug. 14, 2018), https://www.fincen.gov/news/speeches/prepared-remarks-fincen-director-kenneth-blanco-delivered-11th-annual-las-vegas-1; FIN-2019-G001, “Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies,” (May 9, 2019), https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20CVC%20Guidance%20FINAL.pdf.

[18] In the Matter of Mintage Mining, LLC, Tex. State Sec. Board, Order No. ENF-19-CDO-1774 (Feb. 21, 2019), https://www.ssb.texas.gov/sites/default/files/Mintage_ENF_19_CDO-1774.pdf; 2018 Enforcement Report, Tex. State Sec. Board (Feb. 7, 2019), https://www.ssb.texas.gov/sites/default/files/YEAR_IN_ENF_2018_post.pdf; Press release, NASAA, State and Provincial Securities Regulators Conduct Coordinated International Crypto Crackdown (May 21, 2018), http://www.nasaa.org/45121/state-and-provincial-securities-regulators-conduct-coordinated-international-crypto-crackdown-2/; Letter, N.Y. Dep’t of Fin. Servs., In re Bittrex, Inc. (Apr. 10, 2019), https://www.dfs.ny.gov/system/files/documents/2019/04/dfs-bittrex-letter-41019.pdf.


Litigating an SEC Administrative Proceeding

by Luke T. Cadigan

Practice Tips

Cadigan_LukeUnder its new Chair, Mary Jo White, the U.S. Securities and Exchange Commission (the “SEC”) has undertaken a more aggressive approach to enforcement, utilizing numerous new weapons at its disposal.  In connection with this approach, the SEC has indicated that it intends to try more cases in the SEC’s administrative forum, a place with which relatively few attorneys are familiar.

Previously, the SEC could bring cases in this forum only when the respondents were regulated entities, such as investment advisers and broker-dealers, or individuals associated with such entities.  The Dodd-Frank Act of 2010 expanded the forum’s jurisdiction so that the SEC can now bring as administrative cases essentially all the same cases it can bring in federal court.  Assuming an enforcement action can be brought in either forum, the SEC can choose where it wants to litigate and the putative defendant/respondent has no voice in the matter.  The SEC has numerous advantages when it brings a case in the administrative forum.  This article will describe briefly some of the features that can make the SEC’s administrative forum an often challenging place to try a case.  Nonetheless, armed with an understanding of these features, savvy counsel for respondents can often turn these features to their advantage.

Administrative Law Judges

There are no jury trials in SEC administrative proceedings (“APs”).  All cases are tried to a single SEC administrative law judge (“ALJ”), who handles nothing but SEC matters.  Once you know which ALJ has been drawn, you should review all the decisions issued by that ALJ.  Particularly given the specialized nature of the forum, there are likely to be one or more decisions addressing issues in your case.  These decisions may give you a sense of how the ALJ is likely to rule on particular issues and, of course, you will want to cite any favorable decisions in your briefs and distinguish the unfavorable ones.  The ALJ’s decisions will also give you a template for structuring your proposed conclusions of law, findings of fact, and briefs.  You will also want to talk to counsel who have tried cases before the ALJ to learn the ALJ’s preferences and pet peeves.

Prompt Hearings

APs are governed by the SEC’s Rules of Practice (the “Rules”), which can be found on-line at  http://www.sec.gov/about/rulesprac2006.pdf.  The SEC commences an AP with an Order Instituting Proceedings (“OIP”), which contains the Division of Enforcement’s (the “Division”) allegations against the respondent(s) and serves as the charging document.  A respondent has twenty days from service of the OIP to file an answer.

The ALJ will usually accommodate requests to have prehearing conferences conducted by telephone.  The hearing itself will be conducted at a place designated by the ALJ with input from the parties “with due regard for the public interest and the convenience and necessity of the parties, other participants, or their representatives.”  Rule 200(c).  The location chosen is usually that most convenient to the witnesses and respondents and may even be moved mid-hearing depending on what witnesses are scheduled to testify.

In the OIP, the SEC will state whether the ALJ has 120, 210, or 300 days from the OIP service date in which to render its decision (the “Initial Decision”).  This determination is made based on the “nature, complexity, and urgency of the subject matter.” Rule 360(a)(2).  Most litigated APs are sufficiently complex to warrant the 300-day deadline.  Assuming such a deadline, the ALJ will typically issue a scheduling order providing for only approximately four months from the service of the OIP to the hearing.  The parties would then be given another approximately two months to obtain hearing transcripts and submit post-hearing briefs and proposed findings of fact and conclusions of law.  The ALJ issues the Initial Decision approximately four months after briefing.

Given the expedited schedule and the head start that the Division will have by virtue of its investigation, respondent’s counsel should start preparing for the hearing as soon as possible.  You should be ready to receive the Division’s investigative file shortly after service of the OIP, anticipate how the Division is likely to put on its case, prepare your cross-examination of the Division’s witnesses and presentation of your own case, and think through (if not write up) your position on the various legal and evidentiary issues that are likely to arise.  Indeed, the optimal approach would be to start as soon as is practical a rough draft of your post-hearing brief, as well as of the proposed conclusions of law and findings of fact, so that you have a good feel for the facts that you will need to elicit at the hearing and those you will likely have to challenge.  Assuming you submitted a “Wells submission” to the SEC staff, setting forth the reasons no action should be brought, it should provide a good starting point for these documents.  You should also remember that the Division, which typically does not have the resources to dedicate numerous attorneys to any one hearing, will have its own challenges preparing to try a case on such an expedited schedule.

Discovery

The Rules require the Division to turn over their investigative files, including any documents containing material exculpatory evidence (i.e., Brady material) within seven days after service of the OIP.  Rule 230(d).  The Division is permitted to withhold, among other items, privileged documents, work product, internal memoranda, notes and certain other writings prepared by SEC employees, as well as documents that would disclose the identity of a confidential source.  See Rule 230(b).  Clearly, respondent’s counsel needs to review the Division’s investigative files quickly and thoroughly.  These files will reveal the facts and witnesses upon which the Division is relying.  They may also show the facts and witnesses that undercut the Division’s case and reveal gaps in its investigation.

In addition, the Rules provide for production of documents pursuant to subpoenas in advance of the hearing.  Rule 232.  A party may serve a subpoena for documents on anyone, including a third-party or the SEC itself.  Subpoenas for documents or to provide testimony at the hearing may be served nationwide.  See 15 U.S.C. § 78u(b).  With limited exceptions (e.g., Jencks material/witness statements, depositions to preserve testimony of witnesses unlikely to be able to attend the hearing), there is no other discovery permitted in an AP.

Given the limitations on formal discovery (such as depositions), you should make use of the Rule 232 subpoenas as appropriate and consider what informal discovery you can undertake.  For example, you may be able to speak informally with potential witnesses with an eye toward calling or cross-examining them at the hearing.

The Rules provide that a party tendering an expert provide only a brief summary of expected testimony, a statement of qualifications, a list of other proceedings in which the expert has testified, and a list of publications authored.  However, ALJs will often also require production of an expert report.

Admissibility of Evidence

In SEC administrative proceedings, ALJs are to admit all relevant evidence or, put another way, all evidence which “can conceivably throw any light upon the controversy.”  Jesse Rosenblum, 47 S.E.C. 1065, 1072 (1984).  If there is any doubt as to admissibility, ALJs are expected to admit the evidence.  See City of Anaheim, 54 S.E.C 452, 454 & n.7 (1999).  Even hearsay is admissible.  Leslie A. Arouh, 99 SEC Docket 32306, 32323 (Sept. 13, 2010). The low threshold for admissibility is based on the premise that the ALJ and the SEC are capable of assigning appropriate weight to marginally relevant evidence.  However, this threshold is not without limits.  ALJs are required to exclude all evidence that is “irrelevant, immaterial or unduly repetitious.”  Rule 320.

Notwithstanding the low threshold for admission of evidence, respondent’s counsel should strive to develop the relevance of the evidence they present and, as appropriate, to undercut that evidence presented by the SEC.  Even though all the evidence will likely be admitted, you will want to make sure that the ALJ assigns appropriate weight to it.  Also, despite the low threshold and assuming you do not do so too many times, you should not be hesitant to challenge any evidence that you believe to be “irrelevant, immaterial or unduly repetitious.”

Motion Practice

Unlike actions in federal court, there is very little motion practice permitted in administrative proceedings.  Little discovery generates commensurately little discovery motion practice.

As a practical matter, there are also no dispositive motions prior to the hearing.  The Rules provide that a motion for summary disposition be granted “if there is no genuine issue with regarding to any material fact and the party making the motion is entitled to a summary disposition as a matter of law.”  Rule 250(b).  However, summary disposition is usually reserved only for follow-on actions brought by the Division seeking relief on an underlying judgment in a related matter, (e.g., an industry bar following a guilty plea) or those seeking to revoke registration of securities.  As the revision comments to the Rule indicate, “the circumstances when summary disposition prior to hearing could be appropriately sought or granted will be comparatively rare.”  59 SEC Docket 1546, 1576 (June 9, 1995).  During the hearing, at the close of the Division’s case, a respondent may make a motion for summary disposition the same way one might make a motion for a directed verdict in a federal action.

Because most motions are disfavored or not even permitted, counsel for respondents should think carefully before filing such a motion about whether it is necessary and permitted under the Rules.

Appellate Process

Parties seeking to appeal the Initial Decision may make an appeal to the SEC itself, which will consider the record in the case, entertain briefing and argument, and render its opinion on a de novo basis, making credibility assessments as necessary from the written record.  But because the SEC initially determined that there was a sufficient basis for bringing the action, a respondent has a difficult task in convincing the SEC upon appeal that there is no basis for liability.

A respondent may appeal any opinion by the SEC to the Court of Appeals for the District of Columbia or for the Circuit in which the respondent resides or has its principal place of business.  See 15 U.S.C. § 78y(a)(1), 15 U.S.C. § 77i.  Respondents who are concerned about a first appeal to the SEC should also appreciate that the D.C. Court of Appeals has not been a hospitable forum for the SEC.

Conclusion

The SEC has made clear that it will start trying more cases in its administrative forum.  Defendants who had hoped to fight the SEC’s allegations in federal court may find that they are instead respondents in an AP and thus without many of the weapons they had hoped to use, such as the right to a jury, expansive discovery, dispositive motions, evidentiary challenges, or even much time to prepare for trial.  The key to succeeding in this forum notwithstanding the absence of these weapons is understanding the unique features of the forum and preparing accordingly.  Indeed, a respondent who does so may find that there are advantages to litigating in the administrative forum.  A respondent who sees and presses these advantages will get a prompt hearing and has a fair shot of getting a favorable result much more quickly and less expensively than one generally would in federal court.

Luke Cadigan is a partner in the Government Enforcement Group of K&L Gates LLP (Boston office).  Prior to joining K&L Gates, Mr. Cadigan was an Assistant Director and a Senior Trial Counsel in the SEC’s Enforcement Division.  During his nine years at the SEC, he successfully tried several matters, both in federal court and the SEC’s administrative forum.