Federal Appeals Court Holds SEC Administrative Proceedings Are Unconstitutional

Background

Jarkesy began as an SEC administrative enforcement action against George Jarkesy, the founder of two hedge funds, and Patriot28, an investment adviser (collectively, the Petitioners). The Commission alleged that the Petitioners violated various antifraud provisions of the Securities Act, the Securities Exchange Act, and the Advisers Act. After the Commission instituted an administrative enforcement action, the Petitioners sued the Commission in the U.S. District Court for the District of Columbia to enjoin the administrative proceeding based on its alleged unconstitutionality. The district court, however, and later the U.S. Court of Appeals for the D.C. Circuit, held that the courts did not have jurisdiction to hear those constitutional claims preemptively. Instead, the courts held that the Petitioners could raise their constitutional claims only after receiving an adverse final order from the administrative proceeding. Ultimately, the ALJ concluded that the Petitioners committed securities fraud, and the Commission affirmed. The Commission imposed a civil penalty, disgorgement, and a cease-and-desist order.

Fifth Circuit Ruling

After Petitioners appealed the Commission’s findings, the Fifth Circuit held that the Commission’s administrative proceeding process suffered from multiple constitutional deficiencies. 

First, the Commission’s use of its administrative process deprived the Petitioners of their right to a jury trial under the Seventh Amendment. The Court explained that the Seventh Amendment provides a right to a jury trial for “suits at common law,” which includes suits brought under the federal securities laws if the suit includes common-law-like claims (such as fraud) or seeks common-law-like legal remedies (such as a civil penalty). The Court further found that the “public rights” exception to the Seventh Amendment jury right was inapplicable because the antifraud case brought by the SEC did not involve public rights, it was not a new cause of action uniquely suited for Commission adjudication, and requiring a jury trial would not “dismantle the statutory scheme” or “impede swift resolution of the SEC’s fraud prosecutions.” Thus, the majority held that Petitioner’s right to a jury trial attached, and the hearing before an ALJ instead of a jury violated the Seventh Amendment.

Second, a Dodd-Frank Act amendment to the federal securities laws delegated legislative authority to the Commission by providing the Commission with unfettered discretion to choose whether to file antifraud actions administratively or in federal court. The Court concluded that this delegation of legislative authority violated Article I of the Constitution because Congress did not provide any intelligible principle to guide the Commission in the exercise of its discretion. The Court observed that it has been “several decades” since the Supreme Court held that Congress had failed to provide an agency with a sufficient intelligible principle governing a delegation, but it believed the Supreme Court had never “considered the issue when Congress offered no guidance whatsoever.”

Third, the impediments to remove ALJs violated Article II of the Constitution, which provides that the President “take Care that the Laws be faithfully executed.” Under existing law, ALJs are insulated from presidential control by at least two layers of for-cause removal—the Merit Systems Protection Board (MSPB) would have to find good cause, and, in addition, the Commission would have to act on the finding. Because the MSPB and the Commission both have for-cause protection from removal by the President, there are at least two layers of for-cause protection from the President’s ability to remove an ALJ. The Fifth Circuit followed the Supreme Court precedent holding that the two layers of protection provided to members of the Public Company Accounting Oversight Board was unconstitutional.

Because of these constitutional defects, the Court granted the petition for review, vacated the Commission’s decision, and remanded the case for further proceedings consistent with the Court’s opinion.

The Fate of Administrative Proceedings in the Wake of Jarkesy

So far, the Commission has not publicly expressed its views on Jarkesy’s impact. The decision raises significant questions, and the ruling could become a watershed decision that significantly alters aspects of the Commission’s administrative adjudicative powers.

What actions are “akin to” actions at common law, and how might that affect the Commission’s choice of venue?

In its wake, the Commission may feel constrained to file in federal court all enforcement actions alleging violations of the antifraud provisions of the federal securities laws or other violations that “are akin” to actions that arise at common law. What other violations may be “akin” to those at common law is a question that will not always have a clear answer, and the Court itself observed that “some actions provided for by the securities statutes may be new and not rooted in any common-law corollary.” Categorizing causes of action may prove challenging to courts, the Commission, and litigants. In addition, although the majority’s opinion can be read to suggest that any action in which the Commission seeks a civil money penalty must be filed in federal court, it also hints that the rule might not be so strict in actions that do not involve antifraud claims.

Are there any administrative proceedings that the Commission can still bring in the wake of Jarkesy?

The Court’s holding regarding delegation, while no doubt broad, may call into doubt the Commission’s ability to bring actions administratively. Although the Commission has issued settled administrative proceedings in the days since the Fifth Circuit handed down its decision, how it will continue to approach the Court’s findings of unconstitutionality remains to be seen.

Also unclear is the scope of the Court’s delegation finding. While Congress has given the Commission unfettered discretion with respect to where to file suit alleging primary violations of antifraud claims (among others), that choice does not apply to all matters. For example, under the Exchange Act, an allegation that one party caused another’s primary violation is a charge that can be brought only administratively through a cease-and-desist proceeding, so there is no “legislative” choice delegated to the Commission. Similarly, actions brought pursuant to Section 12(j) of the Exchange Act are administrative in nature, as are proceedings against accountants, lawyers, or other experts appearing before the Commission pursuant to SEC Rule of Practice 102(e) and so-called follow-on administrative proceedings to bar professionals from regulated industries after criminal and other sanctions. For these matters, the Court’s holding regarding delegation may be of less consequence. Notably, if the SEC must litigate in federal court, it will also have to meet the “likelihood of future violations” standard to obtain injunctions—a higher standard than applies to entry of a cease-and-desist order in administrative proceedings.

Does Jarkesy require an overhaul of the appointment and structure of ALJs?

The Court’s holding that the structure of an ALJ’s appointment is unconstitutional may be a serious roadblock to bringing any litigated administrative action. Although in theory the Commission or a Commissioner could preside, that is not a practical solution. Instead, it seems more likely that the tenure protection afforded to ALJs will be weakened so that they are less independent from the Commission and the President. While solving one constitutional defect, limiting the independence of ALJs may amplify concerns that respondents in administrative enforcement actions are not afforded due process, because they do not appear before a neutral arbiter and have significant limitations placed on their defense that do not exist in federal court.

Does the ruling bar the Commission from settling cases administratively?

Whether the ruling calls into question the SEC’s ability to settle cases administratively (as opposed to litigating them before an ALJ) is unclear. While it seems clear that settling defendants can waive their right to a jury trial, the nondelegation holding may call into question whether administrative proceedings are permissible at all.

The Path Forward

Given the opinion’s significance, undoubtedly the SEC is evaluating its appellate and other options. In order to continue its use of administrative proceedings in litigated actions, the SEC must clear three separate constitutional hurdles, and the Commission will likely need the help of Congress (or the Supreme Court) to do so. Legislative intervention aside, the Commission is surely considering ways to cabin the reach of the Court’s ruling in pending litigation and in the future.  Only time will tell the ultimate effect of the Court’s ruling. In the meantime, parties and regulated entities should closely monitor how Congress, the Commission, and other courts respond. For now, at a minimum, respondents in administrative proceedings have a new tool in their defensive arsenal.