(Article from Registered Funds Regulatory Update, July 2022)
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The U.S. Court of Appeals for the Fifth Circuit (the “Court”) vacated a decision by the SEC against George Jarkesy Jr. and Patriot28, LLC (together, the “Petitioners”). The Court held that (i) the SEC’s in-house adjudication of Petitioners’ case violated their Seventh Amendment right to a jury trial; (ii) Congress unconstitutionally delegated legislative power to the SEC by granting it full discretion to choose the judicial forum for enforcement actions without appropriate guidance; and (iii) statutory removal restrictions on SEC Administrative Law Judges (“ALJs”) violated the Take Care Clause of Article II of the Constitution. For these reasons, the Court vacated the decision of the SEC and remanded the case for further proceedings.
While the holdings in Jarkesy raise important issues the Supreme Court may consider, the Supreme Court recently granted certiorari in a similar case—SEC v. Cochran. In Cochran, the Fifth Circuit ruled that Constitutional challenges to an administrative proceeding may continue in federal court prior to the conclusion of an administrative hearing. This same argument was made by the Petitioners in the U.S. District Court for the District of Columbia but was denied.
These developments may significantly affect the landscape of future SEC enforcement actions and should be considered as part of a strategy in defending SEC enforcement actions.
Background
Jarkesy established two hedge funds to which Patriot28 acted as the investment adviser. The SEC brought an administrative action against the Petitioners alleging that the Petitions committed fraud under the Securities Act, the Exchange Act and the Advisers Act. Specifically, the SEC charged that the Petitioners: (i) misrepresented who served as the funds’ prime broker and auditor; (ii) misrepresented the funds’ investment parameters and safeguards; and (iii) overvalued the funds’ assets to increase the fees charged to investors. After evidentiary hearings, the ALJ concluded that Petitioners committed securities fraud. The Petitioners then sought review by the SEC, but the SEC affirmed the holding of the ALJ and ordered the Petitioners to cease and desist and pay disgorgement and a civil monetary penalty. Jarkesy was also barred from various securities industry activities.
Petitioners initially sued the SEC in the U.S. District Court for the District of Columbia to enjoin the agency’s proceedings, arguing that the ALJ proceedings infringed upon their Constitutional rights. The District Court refused to issue an injunction and determined it lacked jurisdiction. This is in opposition to the decision in Cochran.
The SEC rejected several Constitutional arguments and determined that: (i) the ALJ was not biased against Petitioners; (ii) the Commission did not inappropriately prejudge the case; (iii) the Commission did not use unconstitutionally delegated legislative power—or violate Petitioners’ equal protection rights—when it decided to pursue the case within the SEC enforcement regime instead of in an Article III court with a jury; (iv) the removal restrictions on SEC ALJs did not violate Article II and separation-of- powers principles; and (v) the proceedings did not violate Petitioners’ Seventh Amendment right to a jury trial. Petitioners then filed a petition for review in federal court.
Holdings
Unconstitutional Denial of Jury Trial
First, the Court held that “the SEC’s enforcement action is akin to traditional actions at law to which the jury-trial right attaches.” The Court explained that although Congress has the power to assign certain proceedings to administrative adjudication, such power is limited to proceedings involving public rights. Congress cannot assign the adjudication of such claims to an agency because such claims do not concern public rights alone.
In coming to this conclusion, the Court first examined whether the claims in the action arose “at common law” under the Seventh Amendment. Second, the Court examined if the Supreme Court’s public-rights cases permit Congress to assign such cases to ALJs without a jury trial. The relevant factors considered were whether Congress created a new right of action and remedies unknown to common law and whether a jury trial would “dismantle the statutory scheme.”
The Court determined that the rights the SEC sought to enforce did arise “at common law” under the Seventh Amendment, as fraud is a common law doctrine and the SEC sought a civil monetary penalty, which is a remedy under common law. In addition, the Court held that a jury trial would not “dismantle the statutory scheme” as the statutory scheme itself permits proceedings to be brought either before an ALJ or an Article III court. As such, securities fraud actions are not uniquely suited for ALJs.
Given the above, the Court held that Petitioners had the “right for a jury to adjudicate the facts underlying any potential fraud liability.”
Unconstitutional Delegation of Legislative Power
Second, the Court held that Congress unconstitutionally delegated legislative power to the SEC when it gave the SEC discretion to choose whether to bring enforcement actions in Article III courts or before an ALJ without providing the SEC with “intelligible principles to guide its use of the delegated power.”
The Court explained that the Supreme Court has previously held that the power to assign disputes to agency adjudication is legislative in nature. The Court noted that when Congress delegates a legislative power it must offer an intelligible principle by which to exercise the power. The Court noted, and the SEC agreed, that Congress offered no guidance whatsoever and that Congress has given the SEC exclusive authority and absolute discretion to decide whether to bring securities fraud enforcement actions with an ALJ or in an Article III court. Therefore, the delegation was unconstitutional.
Given the above, the Court held that because Congress gave the SEC a significant legislative power without guiding principles, the delegation of the legislative power was unconstitutional.
Unconstitutional Statutory Removal Restrictions
Finally, the Court held that the statutory removal restrictions for SEC ALJs are unconstitutional given that SEC ALJs perform substantial executive functions and the President, therefore, must have sufficient control over the performance of their functions. The Court noted that two layers of for-cause protection impede the President’s control over the SEC ALJs, which is forbidden under Supreme Court precedents.
Of primary importance was whether the SEC ALJs serve sufficiently important executive functions and whether the restrictions on their removal are sufficiently onerous that the President has lost the ability to take care that the laws are faithfully executed.
The Court noted that SEC ALJs may only be removed for cause by the SEC Commissioners and the Merits Systems Protection Board (“MSPB”) and that SEC Commissioners and MSPB members can only be removed by the President for cause, which insulates SEC ALJs from the President by two layers of for-cause protection from removal.
For these reasons, the Court held that because SEC ALJs are sufficiently insulated from removal, the President lacks the authority to ensure that the laws are faithfully executed and, therefore, the statutory removal restrictions are unconstitutional.
Jarkesy v. SEC, No. 20-61007, 2022, available at: https://www.ca5.uscourts.gov/opinions/pub/20/20-61007-CV0.pdf.