Supreme Court Limits SEC Administrative Actions, Upholds Defendants’ Right to a Jury

07/02/2024|5 minute read

Key Takeaways:

• In a groundbreaking decision, the U.S. Supreme Court significantly limited the U.S. Securities and Exchange Commission's (SEC or Commission) use of in-house administrative actions by holding that SEC civil enforcement actions seeking civil penalties against a defendant for securities fraud entitle the defendant to a jury trial under the Seventh Amendment of the U.S. Constitution.
• The Supreme Court's ruling essentially prevents the SEC from pursuing civil penalties in securities fraud enforcement actions in administrative proceedings.
• The Court reasoned that the SEC's antifraud provisions replicate common-law fraud, thereby implicating the Seventh Amendment, and found that the "public rights" exception does not apply to these proceedings based on the punitive nature of the civil penalties sought by the Commission.

On Thursday, June 27, the Supreme Court, in a 6-3 decision, held that the Seventh Amendment entitles a defendant to a jury trial in instances where the SEC seeks civil penalties against that defendant for alleged securities fraud. SEC v. Jarkesy, No. 22-859, 1924 U.S. - (U.S. June 27, 2024) (available here).

Background

With the implementation of the Dodd-Frank Wall Street Reform and Consumer Protections Act (Dodd-Frank) in 2010, the SEC gained the ability to pursue civil enforcement actions to obtain civil penalties for securities fraud against a defendant through its in-house administrative proceedings presided over by an SEC-appointed and -paid administrative law judge (ALJ). Thereafter, the SEC began a controversial practice of litigating a higher number of securities fraud-based enforcement actions for civil penalties in SEC administrative proceedings as opposed to federal court. As noted in Justice Gorsuch's concurrence, these administrative proceedings provide defendants with significantly fewer procedural protections than offered by a U.S. District Court. Aside from not being before an independent, life-tenured Article III judge and a jury, defendants experience limited avenues of discovery with a maximum of five oral depositions; they do not benefit from the application of the Federal Rules of Evidence, including that ALJs can rely on hearsay evidence; and defendants face rigid deadlines that can require the proceedings be completed within 10 months even in the most complex of matters. Id. at 4-5 (Gorsuch, J., concurring). Finally, any appeal is made to the five-member commission, which authorized the enforcement action in the first place. Id. at 5.

Jarkesy stemmed from an in-house administrative proceeding the SEC initiated in 2013 against an investment adviser, George Jarkesy Jr., and his firm, Patriot28 LLC, for alleged securities fraud violations. In 2014, the presiding ALJ issued an initial decision. Seven years later, the SEC reviewed that decision, and the final order levied a civil penalty of $300,000 against Jarkesy and Patriot28, directed them to cease and desist committing or causing violations of the antifraud provisions, ordered Patriot28 to disgorge earnings, and prohibited Jarkesy from participating in the securities industry and in offerings of penny stocks. Jarkesy filed a petition for review with the Fifth Circuit.

In May 2022, the Fifth Circuit vacated the fine and other penalties and found that the SEC proceeding violated the Seventh Amendment because the agency obtained civil monetary penalties for fraud claims in a forum where the respondent did not have the ability to have a jury determine liability. The Fifth Circuit also held that Congress' delegation of power to the SEC to choose whether to bring enforcement proceedings in federal court or in administrative proceedings was unconstitutional and that the in-house judges who oversee SEC administrative proceedings are unconstitutionally protected from removal. The SEC petitioned for review by the Supreme Court.

The Court's Opinion

The Court's analysis focused on the question of whether the SEC's use of in-house proceedings to impose civil penalties when it accuses individuals or entities of committing securities fraud implicates the Seventh Amendment. The Court found that the Seventh Amendment protects the right to a jury trial in these proceedings because the SEC's antifraud provisions replicate common-law fraud claims, and the "public rights" exception does not apply in these actions. The Court did not address the other constitutional issues examined by the Fifth Circuit.

The Court found that the securities fraud provisions at the heart of the SEC's claims were akin to a cause of action for common-law fraud in part because they seek monetary relief, which is "a prototypical common law remedy." Civil penalties are "designed to punish and deter, not to compensate" victims of alleged fraud or to restore the status quo. Further, securities fraud and common-law fraud are both aimed at similar conduct, misrepresenting or concealing material facts, and courts often consider common-law fraud cases when deciding federal securities law cases. While they are not identical, the Court dubbed common-law fraud as the "ancestor" to federal securities fraud, both being "legal in nature" and protected by the Seventh Amendment.

The Court also found that the public rights exception to the Seventh Amendment does not apply to these actions. Under this exception, Congress can assign a matter for decision by an agency without a jury in certain limited circumstances. The Court relied on its decision in Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989), to demonstrate that "what matters is the substance of the action, not where Congress has assigned it." The nature of the civil penalties sought by the SEC does not fall within the public rights enforced when, for example, federal agencies collect tax revenue, impose tariffs or uphold immigration laws in areas that involve "government prerogative." The Court also distinguished this case from Atlas Roofing Co. v. Occupational Safety and Health Review Commission, 430 U.S. 442 (1977), the principal case relied on by the SEC, and pointed out that Atlas Roofing concerned adjudication of safety regulations promulgated by the Secretary of Labor that were completely novel and thus not found in the common law. The Court found that Atlas Roofing did not control here, "where the statutory claim is 'in the nature of' a common law suit."

Justice Sotomayor wrote in dissent, joined by Justice Kagan and Justice Jackson, stating that the majority opinion threatens the separation of powers and does not afford the appropriate power to Congress to "assign a particular matter to a non-Article III factfinder." The dissent states that the "long history" of public-rights cases endorsing Congress' practice of assigning to in-house adjudication proceedings the government's rights to civil penalties for violations of a statutory obligation is a "faithful and straightforward application" of prior precedent.

While the majority did not address the other constitutional provisions that were debated, the concurrence highlights them to "reinforce the correctness of the Court's course." Specifically, the Seventh Amendment, Article III and the Due Process Clause of the Fifth Amendment operate together "to limit how the government may go about depriving an individual of life, liberty, or property." That is, the right to a jury trial, the right to an independent judge to preside over the trial and that the trial will comply with certain principles collectively ensure a "fair trial in a fair tribunal," as promised by the Constitution. The concurrence states that each provision requires the same result - that the charges are tried "[i]n a court, before a judge, with a jury."

Conclusion

The SEC's controversial expansion of its use of administrative proceedings to address complex cases involving allegations of securities fraud allegations to obtain civil penalties generated significant challenges to the constitutionality of its administrative proceedings by the securities enforcement defense bar. The Supreme Court's Jarkesy decision is an expected consequence of this and is one of several recent high-profile defeats handed down by the Supreme Court to the SEC. See Kokesh v. Sec. & Exch. Comm'n, 581 U.S. 455 (2017), Lucia v. Sec. & Exch. Comm'n, 585 U.S. 237 (2018), Liu v. Sec. & Exch. Comm'n, 591 U.S. 71 (2020). Defendants will benefit greatly from the advantages of proceeding in an Article III court instead of an administrative law proceeding when they choose to litigate against the SEC. Defendants in federal court are entitled to greater discovery, the applicability of the Federal Rules of Evidence limiting hearsay evidence and having an independent life-tenured Article III judge preside over the litigation. Less clear is what effect this decision will have on administrative enforcement actions taken by other federal agencies that also seek civil penalties. Practitioners should be mindful that Jarkesy certainly may provide a basis to challenge these administrative actions as well.

BakerHostetler's attorneys have extensive experience helping clients with these issues, including defending clients in SEC securities fraud investigations. Please feel free to contact any of our experienced professionals if you have questions about this alert.

Co-authored by Summer Associate, Cynthia Eapen.

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