On Wednesday, in a 2-1 decision, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit ruled in Jarkesy v. SEC that proceedings before an SEC administrative law judge were unconstitutional. Notably, the circuit court found the underlying proceedings unconstitutional primarily due to the lack of a jury trial when the SEC is seeking civil penalties in a fraud action. In the decision’s opening paragraph, which sets the stage for the ruling to follow, the circuit court commented that the SEC often acts as both “prosecutor and judge, and its decisions have broad consequences for personal liberty and property.” The Constitution, however, “constrains the SEC’s powers by protecting individual rights” and “[t]his case is about the nature and extent of those constraints in securities fraud cases in which the SEC seeks penalties.” The circuit court decision is the latest in a series of challenges to the SEC’s administrative authority and is likely to further chill the SEC’s use of administrative proceedings for litigated actions.

Background

George Jarkesy established two hedge funds that raised about $24 million from more than 100 investors. The SEC brought an administrative action against him and his adviser entity, Patriot28, for fraud under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Advisers Act of 1940 alleging misrepresentations regarding the funds’ prime broker and auditor, the funds’ investment parameters and safeguards, and the value of the funds’ assets. Initially Jarkesy and Patriot28 sued the SEC in the U.S. District Court for the District of Columbia and attempted to enjoin the SEC administrative proceeding on constitutional grounds. The injunctive proceeding was unsuccessful¹, and Jarkesy and Patriot28 ultimately were found liable by the SEC’s ALJ. Petitioners appealed to the Commission, which affirmed the ALJ’s decision and ordered petitioners to disgorge $685,000, pay a civil penalty of $300,000, and which barred Jarkesy from securities industry activities. Petitioners raised several constitutional arguments both before the ALJ and to the Commission, including that the ALJ was biased against petitioners, that the Commission inappropriately prejudged the case, that the Commission did not use constitutionally delegated legislative power when it decided to pursue the case in its administrative forum and the proceeding violated petitioners’ equal protection rights, that the removal restrictions for SEC ALJ’s violated Article II and separation-of-powers principles, and that the proceedings violated petitioners’ Seventh Amendment right to a jury trial.

On appeal, the circuit court focused on three constitutional arguments holding that: (1) petitioners were deprived of their constitutional right to a jury trial, (2) Congress unconstitutionally delegated legislative power to the SEC by failing to provide intelligible principles to exercise such power, and (3) the statutory removal restrictions of SEC ALJ’s violated Article II of the Constitution. The circuit court vacated the SEC decision and remanded the case for further proceedings.

In its decision, the circuit court spent considerable time analyzing the constitutional right to a jury trial. The court highlighted that civil juries are an important check to government power citing Thomas Jefferson and the Federalist Papers. The court was not persuaded by the SEC’s argument that the legal interests at issue vindicated distinctly public rights; instead, the court found the rights that the SEC sought to vindicate arise “at common law” and therefore are protected under the Seventh Amendment when the SEC seeks civil penalties in a fraud action.

The court went on to conclude that Congress had unconstitutionally delegated legislative power to the SEC, to seek civil penalties in the administrative forum because the choice to proceed in front of an ALJ or before an Article III judge is in the SEC’s absolute discretion and lacked any “intelligible principle” by which the SEC could exercise its delegated authority.² The court also found the statutory removal restrictions violate Article II. According to the court, ALJ’s must be subject to removal at the direction of the president or senior officers that the president can readily remove. As ALJ’s currently enjoy “for cause” removal protection, as do SEC commissioners, the president’s authority to ensure that laws are faithfully executed is unconstitutionally restrained and, as a result, the statutory removal restrictions on ALJs are unconstitutional.³

Concluding Thoughts

This case is significant both in terms of substance and timing. The circuit court’s focus on petitioners’ right to a jury trial when the SEC seeks civil penalties in a fraud action directly addresses a longstanding complaint by respondents in SEC administrative proceedings. It will be interesting to see if this decision gains traction with other courts and/or with other administrative forums that often are compared to SEC administrative proceedings. This ruling also comes only two days after the U.S. Supreme Court agreed to hear an appeal of a Fifth Circuit en banc decision involving Texas accountant Michelle Cochran, who is making similar constitutional challenges to the SEC’s administrative powers.

FOOTNOTES

¹ The district court, and later the U.S. Court of Appeals for the D.C. Circuit, found that because there was no final order, the district court had no jurisdiction.

² In a footnote, the court explained that this was an alternative holding that provides grounds for vacating the SEC’s decision.

³ The court explained that because it was vacating the SEC’s judgment on other grounds, it did not need to decide if vacating would be the appropriate remedy based on this issue alone.

Adrian L. Jensen and Kathryn Marie Throo also contributed to this article.