What Happens to the SEC's Administrative Proceedings After Jarkesy?
April 2024, Bloomberg Law
One of the more anticipated cases before the Supreme Court this term, at least for administrative law junkies, is SEC v. Jarkesy. Although it is not likely to signal the end of the “Administrative State” as some anticipate, it does seem likely that a majority of the Supreme Court will take the opportunity to address concerns about the in-house adjudications of the US Securities and Exchange Commission (SEC).
The Fifth Circuit decision under review rests on three separate constitutional grounds, so predicting how the Court will decide and what the effects of that decision will be are difficult. Odds are, however, that there could very well be changes to SEC administrative practices coming soon.
After a brief summary of the facts and procedure history, this article will discuss each constitutional issue separately and how, depending on which if any of them the Court decides to rule, the resolution is likely to affect the SEC.
Background
The case focuses on the role and authority of the SEC's administrative law judges (ALJs). In 2013, the SEC brought a cease-and-desist (C&D) proceeding before one of its ALJs against George Jarkesy, the manager of Patriot28 LLC—an investment adviser—and others. The SEC alleged that Jarkesy and the LLC violated the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. In 2020, the SEC found that Jarkesy (and the LLC) violated those provisions and ordered them to cease and desist from further violations, and jointly and severally pay a penalty of $300,000; in addition, the LLC was ordered to pay disgorgement and prejudgment interest of approximately $1,000,000, and Jarkesy was barred from the securities industry. Jarkesy appealed and a divided Fifth Circuit panel found in his favor. See Jarkesy v. SEC, 34 F.4th 446 (5th Cir. 2022). The SEC obtained a writ of certiorari, oral argument has been held, and a decision is expected before the end of the term.
The Fifth Circuit found for Jarkesy on three grounds. First, the panel ruled that Jarkesy was deprived of his right under the Seventh Amendment to a jury trial on the fraud claims which formed the basis of the penalty. Second, the panel ruled that Congress unconstitutionally delegated legislative power to the SEC by failing to articulate an “intelligible principle” to guide its decision whether to seek a penalty for fraud in a district court or an administrative proceeding. Finally, the panel ruled that the removal restrictions enjoyed by the SEC's ALJs violated the “Take Care” clause of Article II. All three questions are before the Supreme Court.
The questions largely arise because of provisions in the Dodd-Frank Act of 2010. In the aftermath of the financial crisis of the late 2000s, Congress amended the securities laws in that act to allow the SEC to seek penalties against “any person” for violating “any provision” of the federal securities laws in an administrative forum. Before that time, the SEC could only seek penalties in an administrative forum for insider trading and against registered entities and their associated persons—who by their registration with the SEC at least theoretically consented to its oversight and discipline. This new authority brought new attention, scrutiny, and opposition to the procedural protections available in that forum.
Right to Jury Trial
At the Nov. 29, 2023, oral argument, the Supreme Court asked questions for more than two hours, focusing mainly on the jury trial issue, which turns largely on two Supreme Court precedents—Atlas Roofing Co. v. OSHA, 430 U.S. 442 (1977) and Tull v. U.S., 481 U.S. 412 (1987). In Atlas Roofing, the Court held that “when Congress creates new statutory ‘public rights,’ it may assign their adjudication to an administrative agency with which a jury trial would be incompatible, without violating the Seventh Amendment's injunction that jury trial is to be ‘preserved’ in ‘suits at common law’.” The Court defined “public rights” as those “cases in which the Government sues in its sovereign capacity to enforce public rights created by statutes within the power of Congress to enact.” In Tull, the Court ruled that “[a]ctions by the Government to recover civil penalties under statutory provisions … historically have been viewed as one type of action in debt requiring trial by jury.” That Court, however, expressly noted that “the Seventh Amendment is not applicable to administrative proceedings,” citing Atlas Roofing.
The Fifth Circuit majority found that the securities fraud actions brought by the SEC were akin to a common law action for fraud, and therefore not entitled to the Atlas Roofing exception for a “public right.” The SEC contests this conclusion. Although both common law fraud and securities fraud generally include a knowing or reckless misstatement of material fact, courts have held that the SEC is not required to prove reliance or damages, elements necessary for a private cause of action. See, e.g., SEC v. Blavin, 760 F.2d 706, 711 (6th Cir. 1985). And the Supreme Court has held that Securities Act Sections 17(a) (2) and (3) do not require a showing of scienter. See Aaron v. SEC, 446 U.S. 680 (1980).
If the Court were to uphold the Fifth Circuit's ruling on Seventh Amendment grounds, it would have at least two curious effects for the SEC to consider.
First, the SEC can seek penalties in administrative proceedings for a violation of “any provision” of the federal securities laws. If the Supreme Court rules that seeking a penalty for fraud requires a jury trial—and does not issue a broader ruling affecting other claims—it would seem to leave the SEC free to pursue penalties in administrative proceedings for non-fraud actions, such as failure to register or maintain required books and records. Such a result could, perhaps ironically, reinforce the “Administrative State”—encouraging the SEC to seek more penalties for more technical claims in more “in-house” proceedings.
Second, the Jarkesy majority (and the SEC) characterized the fraud claims in this case as knowing or reckless material misstatements. As the Supreme Court, however, has noted in a number of decisions over the years: the scope of behavior that can be alleged as fraud under the federal securities laws is considerably broader than simply misstatements. See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 193 (1963), holding “[i]t is not necessary…to establish all the requirements required in a suit for monetary damages” under Advisers Act Section 206); and Lorenzo v. SEC, 139 S. Ct. 1094 (2019), holding that the Exchange Act Rule 10b-5 creates liability for disseminating false information even if the person did not make the false statement.
Moreover, Exchange Act Section 10(b) authorizes the SEC to define “any manipulative or deceptive device or contrivance…as necessary or appropriate in the public interest or for the protection of investors;” Advisers Act Section 206 gives the SEC authority to define conduct “reasonably designed to prevent” fraudulent, deceptive or manipulative practices. The SEC has adopted a number of rules under these provisions, creating causes of action unknown to the common law, which are otherwise treated by the SEC indistinguishably as “securities fraud.” Upholding Jarkesy on the ground that the fraud alleged in that case is comparable to common law fraud therefore could lead to a parsing of fraud allegations in SEC actions, depending on whether they are based on a misstatement or otherwise covered by the securities laws.
Such a dynamic would no doubt affect how the SEC alleges its fraud actions, and almost certainly invite further court challenges. It would also seem to call into question the ability to obtain penalties against registered persons for fraud in administrative proceedings—but perhaps not insider trading, a fraud theory based on a duty to speak, not a misstatement. On the other hand, a decision that the full scope of “fraud” actionable under the federal securities laws are all “private rights” would be difficult to reconcile with the Court's securities law precedents and to defend as analogous to common law fraud.
Delegation of Legislative Power
Congress has authorized the SEC to bring actions against “any person” and seek penalties in either federal district court or an administrative proceeding. The Fifth Circuit panel characterized this choice as a delegation of legislative power. Under long-standing Supreme Court precedent, a delegation of legislative power is only constitutional if Congress provides an “intelligible principle” for the delegated entity to exercise that power. By failing to provide an “intelligible principle” for the SEC to decide how to exercise the choice of which forum to seek a penalty, the Jarkesy majority found the delegation unconstitutional.
The SEC objects to the characterization of choosing between forums as a legislative act. Rather, it characterizes the choice as well within its prosecutorial discretion. The SEC points to U.S. v. Batchelder, 442 U.S. 114 (1979). There, the Court ruled that a prosecutor's ability to choose between two different criminal statutes with essentially the same elements but different legal consequences was not a delegation of legislative authority.
Although both Jarkesy in his brief and the Jarkesy majority in its decision make this argument in the context of a jury trial right, the scope of this argument is not so limited. The question presented on this issue before the Court is “Whether statutory provisions that authorize the SEC to choose to enforce the securities laws through an agency adjudication instead of filing a district court action violate the nondelegation doctrine.” A ruling on this ground therefore calls into question every agency's ability to choose between different forums with different legal processes, regardless of the claim or remedy—if Congress has not also enacted an intelligible principle to guide that choice.
The way forward is unclear if the Court were to uphold that ruling. The Fifth Circuit did not strike down the legislative grant of authority to obtain a penalty for fraud in an administrative proceeding; it simply overturned the SEC's decision. Focusing on the choice, however, expresses no view on which forum is preferable, or even if the availability of a jury trial should be a factor in deciding between them. If the problem is an unconstitutionally delegated choice, the issue disappears if the choice is eliminated. Given the rarity with which the Court has stricken legislation on this basis, however, voiding the legislative authority would seem unlikely here.
If the Court nonetheless raises constitutional questions about this lack of a principle, Congress could conceivably - but not likely in the near term—repeal the ability of the SEC to seek penalties in one or the other forum. Not any likelier, Congress could enact an intelligible principle to guide the SEC's choice.
If the Court raises questions but does not strike down one of the provisions, and in the absence of a new Congressional directive, the SEC could take one of two routes, both of which avoid the delegation issue rather than resolve it. It could choose not to bring any action in an administrative forum, and seemingly avoid the issue altogether. A more limited reaction would be to only seek remedies in an administrative forum for which it does not have express statutory authority in district court, principally C&D (including causing) orders and securities industry bars. It largely seems to be doing this now.
Removal Protections for ALJs
Article II of the Constitution directs the President to “take care that the laws [are] faithfully executed.” The Supreme Court has interpreted this “Take Care” clause as protecting the President's ability to remove inferior officers who impede his or her execution of policy. The Court has in recent years found that the appointed leaders of the Public Company Accounting Oversight Board and the Consumer Finance Protection Bureau enjoyed unconstitutional protections from removal. See Free Enterprise Fund v. PCAOB, 561 U.S. 477 (2010); Seila Law LLC v. CFPB, 140 S. Ct. 2183 (2020). In those cases, the Court simply severed the removal protections from the statutes. The Fifth Circuit panel found that the removal protections the SEC ALJs enjoy similarly interfere with the President's ability to “take care.” If this Jarkesy ruling is upheld, it could have dramatic consequences for ALJs at an independent agency.
The parties in the Jarkesy litigation assume that SEC commissioners could only be removed “for cause.” This was also assumed but not decided in Free Enterprise Fund. The principle extends back to Humphrey's Executor v. U.S., 295 U.S. 602 (1935), in which the Court found that particular language in the Federal Trade Commission Act protected FTC commissioners from removal without cause. The federal securities laws do not have comparable language for SEC commissioners, but the agency has relied on the principle underlying the decision.
The Court recently concluded that the SEC's ALJs were “inferior officers” who needed to be appointed by the “agency head” and are not simply employees. See Lucia v. SEC, 585 U.S. 237 (2018). The Jarkesy majority held that SEC ALJs are too insulated because they enjoy “at least two” layers of protection. The parties to the action disagree about the extent of protections SEC's ALJs enjoy. By statute, ALJs can be removed “only for good cause established and determined by the Merit Systems Protection Board” (MSPB), whose members enjoy their own removal protections. Jarkesy argues that the MSPB provides a separate level of removal protection. The SEC argues that the MSPB simply reviews the agency's determination that the statutory removal has been satisfied.
The Court could resolve this issue in a number of different ways. The simplest decision would be to rule that ALJs, though “inferior officers,” perform solely adjudicative functions. Their protections, therefore, pose no impediment to the President's ability to carry out executive policy. The SEC argues in the alternative that, if there is any defect in the removal protections, the ALJs should be removable without cause by the agency.
The Court could also rule that ALJs’ statutory protections do not insulate them from removal by the President. To get there, the Court could call into question whether SEC commissioners enjoy any removal protection. Unlike the statute at issue in Humphrey's Executor, the federal securities laws are silent on any standard for removing SEC commissioners. More broadly, Justice Thomas (joined by Justice Gorsuch) expressed an interest in his Seila Law concurring/dissenting opinion to revisit the principle underlying Humphrey's Executor altogether, calling the case “a direct threat to our constitutional structure and, as a result, the liberty of the American people.” If the Court were to indicate that the SEC commissioners have no removal protections, it would satisfy the “Take Care” issue (and defeat Jarkesy's claim), but fundamentally change the relationship between the SEC and the President.
Conclusion
Regardless of the outcome, the SEC is likely to continue to settle a significant number of its cases in an administrative forum, largely because subjects of SEC investigations often want to settle in an administrative forum. C&D orders are generally considered less severe—or blameworthy—than a district court injunction. The standard for obtaining a C&D order is less demanding than for an injunction. The parties also avoid the risk that a district court judge might question the terms of the settlement. Administrative claims can be based on such concepts as “willful” conduct and “causing” a violation, which generally have lower standards of culpability than district court analogues. Unless the Court—or Congress—limits the legal ability to resolve cases in an administrative forum, this practice is likely to continue.
Ironically, if Jarkesy is overruled, it could have a significant, practical effect on the SEC. In light of the challenges to its ALJs, the SEC has been behaving as if it had already lost this case. It has been bringing only a handful of litigated cases before its ALJs, mainly seeking remedies that are only available in that forum. If the Court were to reverse Jarkesy, the SEC would likely bring more litigated cases in its administrative forum and again seek penalties there.
On the other hand, the Court may take the opportunity to narrow the scope of “public rights” under Atlas Roofing—perhaps, for example, that they encompass only government benefits. If the Court goes further and finds that the Seventh Amendment extends to any deprivation of liberty or property by the federal government, virtually all litigated claims for most remedies would need to be pursued before juries in federal district court. Finally, if the Court were to rule this way, and the statutes authorizing administrative remedies were struck down or removed by Congress, the SEC's ability to settle cases in an administrative forum would be curtailed or foreclosed. While this may not be the most likely outcome, it would indeed signal a significant change to the “Administrative State.”
Copyright 2024 Bloomberg Industry Group, Inc. (800-372-1033) What Happens to the SEC's Administrative Proceedings After Jarkesy?. Reproduced with permission.
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