By Amanda Maine, J.D.
An SEC administrative law judge (ALJ) rejected an application for recovery of legal fees and expenses from two firms who had prevailed against the SEC’s Division of Enforcement last year and successfully had proceedings against them dismissed. While the ALJ found that the applicants had demonstrated their eligibility for recovery of legal fees and expenses under the Equal Access to Justice Act (EAJA), the SEC’s action had been substantially justified, even though it was eventually dismissed. The decision was the first initial decision issued by an ALJ following the Supreme Court’s Lucia decision, which determined that the ALJ in that proceeding was not appointed by the Commission in conformity with the Constitution. The Commission stayed all administrative proceedings following Lucia, but the stay was allowed to expire on August 22. The applicants waived their rights under Lucia to a new hearing before a different judge (In the Matter of Donald F. ("Jay") Lathen, Jr., Release No. ID-1259, Patil, S.).
Initial decision. In August 2016, the SEC instituted proceedings against hedge fund manager Donald F. "Jay" Lathen, his advisory firm Eden Arc Capital Management, LLC (EACM), and the general partner to his hedge fund, Eden Arc Capital Advisors, LLC (EACA). The SEC alleged that Lathen and his firms paid terminally ill individuals to use their names on purportedly joint brokerage accounts so he could purchase investments on behalf of his hedge fund and redeem them early by invoking a survivor’s options. He allegedly failed to disclose side agreements that he signed with his fund and with the terminally ill participants. The SEC had also alleged violations of the SEC’s custody rule. ALJ Jason S. Patil dismissedthe proceedings in April 2017, finding that Lathen lacked an intent to defraud and that the custody rule in this situation did not apply to EACM.
EAJA. In December 2017, EACM and EACA (applicants) filed for recovery of legal fees and expenses under the EAJA. The EAJA requires that the applicants show that they are eligible for recovery by showing a net worth of less than $7 million and that legal fees have been "incurred" in connection with the proceeding. After the applicants establish eligibility, the Commission can argue against recovery of legal fees by showing that it was "substantially justified in bringing the proceeding."
Eligibility. ALJ Patil determined that the applicants were eligible under the EAJA. Documents submitted by EACM and EACA showed a net worth of a little over $1,000 for each. Lathen himself submitted a net worth statement with over one thousand pages of documentation supporting his claimed net worth of approximately $428,000. Even taking into account the net worth of affiliate Eden Arc Capital Partners, LP ("the Partnership") of $6,207,438, although "perilously close" to the $7 million threshold, the applicants met their burden, the ALJ found.
The ALJ also rejected the Enforcement Division’s argument that the fees were not "incurred" because the Partnership paid their legal fees and expenses. The ALJ took issue with the Division’s reliance on precedent establishing that fees have not been incurred when an employer paid the attorney fees an employee, distinguishing the matter at hand because the Partnership’s payment of fees did not eliminate the deterrent effect as it was not a third-party employer, but an affiliated entity with intertwined interests and a fiduciary relationship. Eligibility having been established, the burden shifted to the Division to show substantial justification in bringing the original proceedings.
Substantial justification. The ALJ noted that, while he had dismissed the original proceedings, the outcome of the underlying case is not dispositive as to whether the Division was substantially justified in bringing those proceedings. He noted that, in the end, his decision hinged on the issue of scienter and that not only had Lathen believed that he found a "legal loophole," several attorneys agreed with him.
However, the ALJ stated that a reasonable person could find that Lathen’s failure to disclose the side agreements was reckless because he knew that joint tenancy law was unsettled, that his interpretation was a novel one, and that some of his lawyers warned him of risks in the investment model. For similar reasons, it is plausible from the facts in the record that Lathen acted negligently, according to the ALJ. While he had found that Lathen was not negligent, it was largely because the Division failed to present appropriate evidence of the standard of care to which Lathen should be held, he advised.
As such, while the Division’s allegations of knowing fraud were not substantially justified, its allegations of recklessness and negligence were substantially justified. The ALJ also found that the Division’s allegations that the investment management agreement created a structure that violated the custody rule were reasonable, and therefore substantially justifiable.
Finding that the Division of Enforcement’s position was substantially justified, the ALJ denied the application to recover fees under the EAJA.
The release is No. ID-1259.