Supreme Court in Jarkesy Limits the SEC’s Powers to Use In-House Administrative Courts

Yesterday, the Supreme Court issued its decision in the closely-watched SEC v. Jarkesy, holding that the SEC could no longer seek civil monetary penalties for fraud in its in-house courts consistent with the Seventh Amendment, which grants the right to a jury trial and thus requires such cases to be heard in federal court. The Supreme Court’s decision has potentially profound implications, not only for the SEC’s regulation of the securities industry, but for dozens of federal administrative agencies that, depending on the authorizing statute, can or must impose civil penalties through administrative proceedings.

Legal commentators, including sitting federal judges like the Honorable Jed Rakoff of the Southern District of New York, have long been critical of the continued expanding reach of the SEC in utilizing its in-house administrative proceedings, rather than civil actions in the federal courts, to impose civil monetary penalties on individuals and companies subject to its purview. According to these critics, the SEC’s expansive administrative powers were relatively recent creations of the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010, and these critics questioned the use of administrative proceedings to shape precedent for interpreting case law under the anti-fraud provisions of the federal securities laws. Common criticisms also focused on the fact that SEC administrative proceedings are not subject to the Federal Rules of Evidence or the Federal Rules of Civil Procedure, and litigants believed the SEC often enjoyed a higher degree of success in cases brought before its own ALJs than it did in cases brought before Article III judges.[1]

Background

After George Jarkesy, Jr. established two hedge funds and raised approximately $24 million in funds from over 100 investors, the SEC brought administrative proceedings against him and his unregistered investment adviser (Patriot28), alleging various violations of Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act, and Section 206 of the Investment Advisers Act. The conduct alleged included, among other things, misrepresenting the funds’ investment parameters and safeguards, and overvaluing the funds’ assets to increase fees it could charge investors.

Jarkesy first challenged the SEC’s authority to impose civil penalties in administrative proceedings back in 2014, before the DC District Court, seeking an injunction to prevent those proceedings from moving forward. Jarkesy argued that the proceedings infringed on his constitutional rights, including his right to a trial by jury under the Seventh Amendment. Judge Beryl Howell denied Jarkesy’s motion and dismissed the case for a lack of subject matter jurisdiction, requiring Jarkesy to continue with the SEC’s proceedings and appeal any final adverse order to the district court.

In the ensuing SEC administrative proceedings, the ALJ found that Jarkesy had committed securities fraud and the SEC then ordered Jarkesy to pay a civil penalty of $300,000, with his investment advisory company forced to disgorge $685,000 in ill-gotten gains. Jarkesy was also barred from various securities-related activities. In affirming the ALJ’s decision, the SEC rejected Jarkesy’s argument that it had utilized “unconstitutionally delegated legislative power” to pursue the case in an administrative proceeding, rather than in an Article III court, as well as Jarkesy’s argument that the proceedings violated his Seventh Amendment right to a jury trial.

Jarkesy appealed to the Fifth Circuit, raising several constitutional challenges. The Fifth Circuit agreed, ruling that the SEC’s administrative proceedings suffered from three significant constitutional defects: (1) that it deprived Jarkesy of his Seventh Amendment right to a jury trial; (2) that Congress “unconstitutionally delegated legislative power to the SEC by failing to provide it with an intelligible principle by which to exercise the delegated power”; and (3) that statutory removal restrictions on SEC ALJs violated Article III. 

The SEC petitioned for certiorari, which the Supreme Court granted, and the Court heard oral argument on November 29, 2023. 

Supreme Court’s Decision

Chief Justice Roberts, in a 6-3 decision, narrowed the scope of the Fifth Circuit’s decision, holding only that the SEC’s imposition of civil monetary penalties through administrative proceedings violated Jarkesy’s right to a trial by jury for all “suits at common law.” As the Court explained, claims for securities fraud violations (such as fraudulent and misleading statements) are a “suit at common law” to which the Seventh Amendment applies, even though these claims are statutory in nature, because the right to a jury trial under the Seventh Amendment applies to any “statutory claim if the claim is ‘legal in nature.’” Because civil penalties are a form of “monetary relief” and a “type of remedy at common law that could only be enforced in courts of law”,” the Seventh Amendment applies. Because those penalties were also “designed to punish and deter, not to compensate,” any defendant must be “entitled to a jury on these claims”.” 

The majority and dissent sharply diverged as to whether the “public rights exception” to the Seventh Amendment applied SEC proceedings seeking civil penalties.  That doctrine allows Congress to create a “public right” that can be freely “assign[ed] . . . for decision to an agency without a jury, consistent with the Seventh Amendment.” On appeal, the SEC sought cover within the public rights exception. The majority rejected this argument, holding it did not apply because the SEC’s suit was one that “presumptively concern[ed] private rights” based upon historical precedent (the anti-fraud provisions of the federal securities laws are modeled on historical common-law fraud claims), thereby making “adjudication by an Article III court . . . mandatory.” Even though Congress created the right to seek civil penalties administratively through a statutory regime and then assigned that right to the SEC, the focus must be on the “substance of the action, not where Congress has assigned it.” As such, the majority refused to permit Congress to “siphon this action away from an Article III court.” The minority strenuously disagreed, arguing that the focus must be whether Congress gave the right in question to the federal government and the applicable federal agency. As Justice Sotomayor noted, “[t]oday, for the very first time, this Court holds that Congress violated the Constitution by authorizing a federal agency to adjudicate a statutory right that inheres in the Government in its sovereign capacity.” For the minority, claims in which the Government was the claimant fall squarely within the public rights exception, and the majority's decision took “a wrecking ball to this settled law and stable government practice.”

The dissent focused on the broader impact of the majority’s reasoning, which is not necessarily limited to only the SEC’s administrative proceedings. The dissent warned that any administrative agency that seeks to adjudicate claims and impose civil penalties for statutory violations in administrative proceedings can no longer be considered constitutionally sound. Thus, per the dissent, the Jarkesy decision upends years of Supreme Court precedent creating a body of law believed to be “long settled” and “unchallenged for half a century” under which federal agencies operated, placing “hundreds of statutes . . . in peril” and potentially stripping “dozens of agencies . . . of their power to enforce laws enacted by Congress.” For the minority, this “massive sea change” represented a “power grab” by the majority, one in which it “arrogate[d] Congress’s policymaking role to itself.” 

Having decided the case solely on Seventh Amendment grounds, the Court declined to address the remaining two questions presented: (1) whether Congress’s having vested the SEC with authority to enforce the securities laws through agency adjudication rather than before an Article III court violated the non-delegation doctrine; and (2) whether Congress violated Article II by granting for-cause removal protection to ALJs in the SEC and other agencies whose heads enjoy for-cause removal protection.

In conclusion, the Court plainly stated: “A defendant facing a fraud suit has the right to be tried by a jury of his peers before a neutral adjudicator.  Rather than recognize that right, the dissent would permit Congress to concentrate the roles of prosecutor, judge, and jury in the hands of the Executive Branch.  That is the very opposite of the separation of powers that the Constitution demands. Jarkesy and Patriot28 are entitled to a jury trial in an Article III court.”

What The Opinion Did Not Address

The Jarkesy decision leaves open several questions:

1. While Jarkesy clearly restricts the SEC’s ability to pursue civil penalties for anti-fraud violations modeled on common law fraud, what happens to the SEC’s ability to seek civil penalties for violations of other SEC regulations besides the anti-fraud provisions? For example, this implicates common regulations under the 1940 Act, such as requirements to maintain books and records, Form ADV registrations, and other regulations that are not premised on common-law, private rights. The SEC may argue these remedies fall within the public rights exception and therefore remain available through administrative proceedings.

2. Can the SEC continue to pursue disgorgement remedies in administrative proceedings? The majority’s opinion does not directly address disgorgement but observes that remedies that punish are not equitable in nature and thus give rise to the right to a jury trial. The SEC may argue that disgorgement does not fall into the “punishment” camp and therefore remains appropriate for administrative proceedings.

3. Can the SEC continue to pursue administrative bars on future conduct in administrative proceedings? 

4. How Jarkesy will affect matters currently pending before the SEC’s administrative proceedings? What happens to cases in which the SEC is seeking both civil penalties and bars on future conduct?

5. Will Jarkesy apply retroactively to permit past defendants to challenge civil penalties the SEC won in administrative proceedings? While the opinion is silent on this issue, intrepid attorneys will likely challenge past proceedings.

6. To what extent will the SEC continue to bring administrative actions against registered investment advisers (Patriot28 was an unregistered adviser) and other regulated registrants like broker-dealers and transfer agents?

In coming years we expect to see constitutional litigation over these issues to work their way through the courts, potentially inviting further attention from the Supreme Court.

Mintz's Takeaways

The ultimate impact of Jarkesy remains unclear, especially as concerns the broader federal administrative and regulatory scheme. Justice Sotomayor’s dissent warns that Jarkesy's holding is not restricted solely to the SEC and could impact any federal agency that uses administrative law judges to adjudicate otherwise private rights of law. For Justice Sotomayor, “momentous consequences” will follow from majority’s “insistence that the Government’s rights to civil penalties must now be tried before a jury in federal court,” which “pulls a rug out from under Congress without even acknowledging that its decision upends over two centuries of settled Government practice.” 

As Justice Sotomayor observed, Congress enacted upwards of two hundred statutes allowing federal agencies to impose civil penalties for statutory violations. Agencies that, before Jarkesy, could pursue civil penalties administratively include the CFTC, the CFPB, the FDA, OSHA, the EPA, and FERC. And some administrative agencies (e.g., OSHA and FERC) have no congressional authority to pursue civil penalties in cases before an Article III court. Jarkesy suggests that civil penalties must be pursued either in federal court, or not at all. Defendants facing penalties akin to those the SEC sought against Jarkesy now have a powerful argument to assert their jury trial rights in the face of threatened enforcement action. And for those defendants regulated by agencies who lack authority to proceed in federal court, they have a strong argument that any civil monetary penalty is constitutional infirm.

For the SEC, Jarkesy’s practical impact may be modest. Over the past several years, the SEC has ramped down its use of in-house courts when pursuing civil penalties, in favor of federal court proceedings. This follows from the Court’s 2018 opinion in Lucia v. Securities and Exchange Commission that significantly restricted the SEC’s use of ALJs. As a result of that case, the SEC reduced its use of ALJs and refocused on bringing its cases mainly in federal court. But moving all proceedings to federal court could strain the SEC’s limited resources due to the comparatively greater burden of litigating in federal court, where discovery is broader and case timelines are longer. There is little doubt that the Jarkesy decision will make the SEC’s and other agencies jobs’ more difficult, requiring additional time and resources to litigate cases to conclusion. 

The majority’s opinion also does not address the practical realities of its decision, such as the increased burden on Article III courts’ already-busy dockets, the strain on resources the administrative agencies will now face, and the fact that Congress will likely not authorize additional funds for these agencies to pursue matters in federal court. Administrative agencies lack infinite resources, and the practical import of the majority’s decision will likely mean fewer overall cases being brought absent a funding increase from Congress.