In what may prove to be an important development in the field of administrative law, on May 18, 2022, the United States Court of Appeals for the Fifth Circuit issued an opinion in the case of Jarkesy v. the Securities and Exchange Commission (“SEC”), which vacated certain prior findings of securities fraud in an SEC administrative enforcement action. Jarkesy v. S.E.C., 34 F. 4th 446 (5th Cir. 2022) (hereafter “Jarkesy”). The full text of the opinion can be found here. This decision is significant because it calls into question, on constitutional grounds, much of the current enforcement regime employed by the SEC, primarily in the form of evidentiary trials before Administrative Law Judges (“ALJs”).

Background

Tasked with broad oversight of investment markets, products and players, the SEC, like most administrative agencies, has both rulemaking and adjudicatory powers. The SEC enforces its rules through internal administrative proceedings, overseen by ALJs. Over time, the adjudicatory powers of the SEC, including the ALJs, have been broadened, both by statute and through judicial interpretation, and most notably of late by the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010.

Facts and Holdings

Prior to 2011, George R. Jarkesy, Jr. and his investment adviser, Patriot28, LLC (together the “petitioners”) established two hedge funds, which secured, in the aggregate, over 100 investors and managed over $20 million in assets. In 2011, following an internal investigation, the SEC brought an administrative action against the petitioners, alleging securities fraud and seeking both monetary and equitable relief. Following an evidentiary hearing, an SEC ALJ ruled that the petitioners had committed securities fraud. They were ordered to pay disgorgement and a civil penalty and George Jarkesy was barred from engaging in various industry activities.

On appeal, the Fifth Circuit found in favor of the petitioners, vacating the prior SEC decision and remanding for further consideration. In doing so, the Court issued three key holdings:

1. Because the SEC’s internal proceedings were similar enough to traditional actions at common law, its use of an ALJ to adjudicate such claims deprived the petitioners of their Seventh Amendment right to a jury trial;
2. In giving the SEC full discretion to decide whether to bring actions in Article III courts or internally before an ALJ, Congress’s delegation of legislative power to the SEC was overly-broad and, therefore, unconstitutional; and
3. Restrictions on the removal of ALJs, as per current statutes, were unconstitutional (thereby resolving an issue left open by the United States Supreme Court in Lucia v. SEC^[1]).

Jarkesy was a 2-1 decision, with Judge Davis penning a dissent which argues that (i) SEC enforcement actions involve “public rights” to which a jury trial does not necessarily attach; (ii) the delegation of power to the SEC by Congress was sufficient to satisfy the nondelegation doctrine; and (iii) because an ALJ’s function is purely adjudicative, and its powers recommendatory, current removal restrictions on ALJs are not unconstitutional.

Implications

Jarkesy calls into question the SEC’s ability to adjudicate actions under its current enforcement regime. In the absence of the ALJ-based system, such actions would instead proceed in federal court and additional federal judges would be needed to address the influx of new cases. This could chill SEC enforcement actions and result in longer case timelines from initiation to resolution. In the face of such resource restrictions, the SEC might be forced to be more selective in deciding which cases to pursue.

Next Steps

The SEC has not advised whether it will appeal the Fifth Circuit’s decision. However, given the scope and implications of the decision, an appeal seems likely. In the interim, anyone involved in SEC administrative actions should be sure to preserve any constitutional-based claims that could be brought during such proceedings.

Research provided by Olaleye A. Onikuyide, Summer Associate.

[1] Lucia v. S.E.C., 138 S. Ct. 2044, 201 L. Ed. 2d 464 (2018).