Risk Management and Crisis Response Blog

Has the American judiciary closed the door on SEC administrative courts?

Dec 19, 2022 9 MIN READ
Authors
Lawrence E. Ritchie

Partner, Disputes, Toronto

Jayne Cooke

Associate, Disputes, Toronto

Courtroom jury box

In yet another of a long line of cases that could impact the enforcement tools available to capital market regulators south of the border, a split panel of the Fifth Circuit ruled several elements of the United States Securities and Exchange Commission’s (the SEC) administrative proceedings unconstitutional earlier this year. On May 18, 2022, in Jarkesy v. Securities and Exchange Commission (Jarkesy), the Fifth Circuit Court held that the SEC’s in-house courts, composed of administrative law judges (ALJs), deprive individuals accused of SEC infractions of the constitutional right to a jury trial. The Fifth Circuit also concluded that existing legislation unconstitutionally authorizes the SEC to choose the forum for enforcement actions without appropriate guidance. Finally, although not concluding that this issue would necessarily be sufficient to vacate the case, the Fifth Circuit held that existing legislation unduly restricts the President’s ability to remove ALJs.

The structure and history of SEC administrative proceedings

As in Canada, administrative proceedings pursued by the SEC bear several differences from their counterparts in the court system, making them a desirable route for regulatory enforcement staff seeking to enforce various securities law prohibitions. Broadly speaking, administrative proceedings are typically characterized by less stringent evidentiary and procedural rules. In addition, the SEC’s administrative processes may be decided by ALJs who are delegated decision makers vested with authority from the Commissioners of the SEC. ALJs receive their authority from the SEC’s enabling legislation.

Prior to the introduction of the Dodd-Frank Act, unregistered individuals could only face SEC civil penalties in the federal court system. However, since 2010, the Dodd-Frank Act has vested the SEC with the power to adjudicate allegations of securities infractions within its in-house administrative system. This expanded administrative power, however, has not been free from controversy. Jarkesy represents the latest challenge to the constitutionality of the SEC’s administrative process and its use of ALJs. See our previous blog posts relating to this issue from July 2016 and June 2015.

Background of Jarkesy

The Jarkesy case dates back to 2011, when the SEC initiated an investigation relating to securities fraud against both Jarkesy (a hedge fund manager) and Patriot28 (an investment advisor). While the facts underlying Jarkesy are not particularly relevant, it is notable that the SEC’s investigation ultimately culminated in an administrative action wherein the SEC sought both monetary and equitable relief. At the conclusion of the administrative proceedings, the ALJs held that Jarkesy and Patriot28 both improperly overvalued their investment funds’ assets and misrepresented their insurance in order to charge their investors higher fees.

Jarkesy and Patriot28 subsequently appealed this decision to the Fifth Circuit Court. In this appeal, the petitioners raised three issues relating to the constitutionality of the SEC’s structure and authority:

  1. The SEC’s administrative proceedings violate a person’s Seventh Amendment right to a jury trial.
  2. The SEC’s power to choose whether a case is brought before an ALJ represents an unconstitutional delegation of legislative power by Congress.
  3. The removal for cause processes within the SEC violate Article II, as they unduly restrict the President’s ability to remove ALJs.

The Fifth Circuit’s ruling

With a divided 2–1 majority, the Fifth Circuit ultimately agreed with Jarkesy and Patriot28 on all three arguments.

1. The right to a jury trial

Evidently, civil juries provide a check on government power and serve as a fundamental component of the legal system. In the United States, the right to a jury trial is constitutionally protected for “suits at common law” by the Seventh Amendment. Through Supreme Court jurisprudence, “suits at common law” has been interpreted to include all actions akin to those brought at common law — particularly in the event that they seek common-law-like remedies.

As explained by the Fifth Circuit, Congress may assign an action to administrative adjudication if the proceedings centre on “public rights.” This determination is considered through the lens of the two-stage analysis outlined by the Supreme Court:

  1. whether the claims in the action “arise ‘at common law’ under the Seventh Amendment”; and
  2. if so, whether Congress was permitted to assign the claims to agency adjudication without a jury trial. This stage of the analysis requires determining: (1) whether Congress created a new cause of action and remedies unknown to the common law because traditional rights and remedies were inadequate to cope with a manifest public problem; and (2) whether jury trials would “go far to dismantle the statutory scheme” or “impede swift resolution.”

On the first point, the Fifth Circuit held that the securities fraud charges in question in Jarkesy were akin to traditional fraud prosecutions under the common law, which generally incorporate the right to a jury trial. This was particularly so given the fact that the SEC sought civil penalties against Jarkesy and Patriot28. On the second point, it was held that a jury trial in a securities fraud suit would not “dismantle the statutory scheme” addressing securities fraud nor “impede swift resolution” on the SEC’s fraud prosecutions.

Accordingly, the Fifth Circuit concluded that the Seventh Amendment guaranteed Jarkesy and Patriot28 the right to a jury trial given the clear similarities between the SEC’s enforcement action and traditional common law actions to which the jury-trial right attaches. This was not an instance where Congress could assign the claims to an administrative action, as the claims did not exclusively concern public rights. Accordingly, the failure to provide Jarkesy and Patriot28 the right to a jury trial represented an unjustified infringement of their constitutional rights.

2. The SEC’s discretion to choose the forum in which enforcement actions are brought

Secondly, the Fifth Circuit considered the constitutionality of the SEC’s unfettered discretion under the Dodd-Frank Act to decide whether a case should be assigned to an Article III court or before an ALJ.

The Fifth Circuit concluded that the power to decide whether an enforcement proceeding is brought in a court versus an administrative proceeding is inherently legislative in nature. In making this decision, the SEC is effectively vested with the power to determine which defendants have the right to receive certain legal processes — including, among others, the right to a jury trial. In the event that such a legislative power is to be delegated, Congress is required to offer an intelligible principle for this delegation. With respect to the SEC, Congress failed to supply an intelligible principle for the SEC’s ability to exercise this decision, with the Fifth Circuit noting that Congress has “offered no guidance” whatsoever. Accordingly, the Fifth Circuit declared this discretion unconstitutional.

3. The statutory removal restrictions for ALJs

Finally, the Fifth Circuit considered the constitutionality of the statutory removal restrictions for SEC ALJs. Given the ALJs’ important executive function, the Fifth Circuit held that the President must have sufficient control over the performance of their functions and be able to choose who holds the positions. The SEC’s statutory scheme, which incorporates two stages of for-cause protection, presents an unconstitutional impediment to this presidential control. These restrictions ultimately served as an unconstitutional insulation from removal that prevent the President from ensuring that laws are faithfully executed.

Potential implications

While the majority ruling in Jarkesy apparently applies only in Texas, Louisiana and Mississippi, its potential implications may be more far-reaching. In the event that the decision is reviewed and subsequently upheld in the United States, there may be widespread implications for other facets of the administrative state. For instance, the decision’s impact may be broadened to other administrative bodies including, among others, the Federal Trade Commission and the Consumer Financial Protection Bureau.

Broadly speaking, and notwithstanding the unique circumstances of the SEC’s administrative processes in contrast to the Canadian regulatory structure, the issues raised in this and related cases do display the distinctions between the adjudicative powers of the administrative state and those of the traditional court system. However, the decision seems to be grounded, at least in part, on the right to a jury in the American system which is not so grounded in the Canadian experience.

Notably, the release of the Jarkesy decision came on the heels of announced structural and governance changes announced by the Ontario Securities Commission (the OSC). Among other things, these changes include the bifurcation of the OSC’s tribunal and regulatory functions, culminating in the launch of the Capital Markets Tribunal. The announcement of the implementation of these changes at the OSC follows the publication of its Statement of Priorities. Among other things, the Statement of Priorities also highlights the intended independence of the adjudicators and the adoption of Adjudication Guidelines, which are meant to enhance the transparency and perception of even-handedness of the OSC’s adjudicative processes.

Request for review denied

On July 1, 2022, the SEC and the United Stated Department of Justice (the DOJ) jointly filed a petition [PDF] requesting an en banc review of Jarkesy by the Fifth Circuit. If granted, this would have entailed a rehearing of the case in front of all Fifth Circuit judges. In its petition for a rehearing, the SEC and DOJ argued that the current decision is contrary to prior Supreme Court jurisprudence and involves exceptionally important issues worthy of review.

On October 22, 2022, the Court of Appeals denied [PDF] this petition. Notably, this was a split decision with six judges voting that the decision should be reheard. As stated by one of the dissenting judges, Judge Catharina Haynes, “Beyond its massive impacts on the directly involved statutes, the opinion’s potential application to agency adjudication more broadly raises questions of exceptional importance.” The impact of the upheld Jarkesy opinion on the SEC’s ability to bring contested enforcement cases in cases where there is an available concurrent federal court forum will likely emerge in the months to come.

The denial of the petition for a rehearing in Jarkesy came just weeks before the Supreme Court heard arguments in the companion cases of Axon Enterprise v. Federal Trade Commission (Axon) and Securities Exchange Commission v. Cochran (Cochran) on November 7, 2022. Similarly to the issues underlying Jarkesy, Axon and Cochran centred upon the question of when and where constitutional objections to agency power may be pursued. In hearing these cases, the majority of the justices of the Supreme Court appeared to be prepared to take the position that constitutional objections to these agencies may be raised prior to the completion of administrative proceedings. These preliminary signals by the Supreme Court, coupled with the decision by the Fifth Circuit in Jarkesy, have the potential to generate far-reaching consequences for agency adjudications that should be followed closely in the securities regulatory context.