When the Securities and Exchange Commission decides to bring charges against a company or individual, it has two options—sue in federal court, where defendants receive all the familiar procedural protections, or initiate an administrative proceeding.
In an administrative proceeding, the SEC is not just the prosecutor, but it also serves as judge and jury. These in-house proceedings are before administrative law judges (ALJs), who are appointed by the SEC. And the SEC has historically won cases at a much higher rate in these proceedings.
ALJs have extremely broad powers, including the power to impose penalties and permanently bar people from the industry. This includes barring certified public accountants and securities lawyers from practicing before the SEC.
Defendants have objected to this system perennially, arguing that it is both unfair and unconstitutional. These arguments are now finding traction in court.
Jarkesy v. SEC is one of the most significant developments in this area. The May 18 ruling from the US Court of Appeals for the Fifth Circuit severely limits the SEC’s use of administrative proceedings, and could signal a fundamental change in how cases are litigated by the SEC, which might benefit defendants.
The Jarkesy Decision
The SEC instituted in-house enforcement proceedings against George R. Jarkesy Jr. and his advisory firm Patriot28 LLC for allegedly misrepresenting the assets and operations of two hedge funds. Jarkesy sought to enjoin the proceedings, arguing they violated his constitutional rights, but his efforts failed in federal court.
The ALJ and the SEC ultimately found Jarkesy and Patriot28 committed securities fraud, entering civil penalties, disgorgement, and an industry bar. The appeal to the Fifth Circuit ensued.
A divided Fifth Circuit held that the SEC’s in-house court system was unconstitutional in its current form and that the proceeding violated Jarkesy’s Seventh Amendment right to a jury trial.
The court also held that Congress “unconstitutionally delegated legislative power” to the SEC when it gave “no guidance whatsoever” as to when the SEC should initiate administrative proceedings as opposed to filing suit in federal court. Finally the court held that the SEC’s ALJs were too far insulated from removal by the president, violating the separation of powers.
Impact of Ruling
The significance of the Jarkesy decision cannot be overstated, and for that reason the SEC on July 1 asked the full Fifth Circuit to reconsider the ruling. Depending on the outcome of the petition, the commission could also seek US Supreme Court review.
If the Jarkesy decision stands, it could lead to fundamental changes in the way the SEC has operated for decades. In the wake of Lucia v. SEC, which held that the commission’s ALJs had been unconstitutionally appointed, the SEC began to bring the bulk of its contested enforcement actions in federal court.
If Jarkesy were to become the law in other circuits, what may have been a temporary move to federal court could become permanent, given the continued success defendants are having in challenging administrative proceedings.
Just two days before Jarkesy was decided, the Supreme Court agreed to hear the SEC’s appeal of Cochran v. SEC, which permitted defendants to go to federal court as an initial matter to challenge the constitutionality of the SEC’s in-house court system rather than forcing defendants to endure a full administrative proceeding and an appeal to the commission before doing so.
If the Supreme Court affirms Cochran, defendants will be able to fast-track their constitutional challenges. Even before then, the combined impact of Cochran and Jarkesy will likely embolden defendants to bring their challenges in federal court.
With courts now willing to entertain existential challenges to the SEC’s administrative proceedings, it could signal a major change in the way SEC enforcement actions are pursued and resolved.
While we wait for the various appeals to be resolved, defendants still face the risk of defending against claims brought in what at least one court has held is an unconstitutional system.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Susan E. Hurd is a partner in Alston & Bird’s Securities Litigation Group. She represents companies and their executives in securities class actions, derivative cases, merger litigation, and SEC investigations.
Matthew E. Newman is a senior associate in Alston & Bird’s Securities Litigation Group, focusing on complex securities litigation, SEC and DOJ investigations, and regulatory and compliance matters.