The United States Court of Appeals for the Fifth Circuit issued a major decision on May 18, 2022 holding Securities and Exchange Commission (SEC or Commission) administrative adjudications unconstitutional on multiple grounds. In Jarkesy v. SEC,¹ the Fifth Circuit held, over a dissent, that the SEC may not bring a securities fraud enforcement action before an in-house administrative law judge (ALJ) because that statutory framework independently violates the authority of all three branches of the federal government. The court held that:

1. The SEC’s in-house adjudication of securities fraud claims infringed on the authority of the Judicial Branch by depriving petitioners of their Seventh Amendment right to a jury trial;
2. The SEC’s unfettered discretion to bring an enforcement action in court or in-house violated the authority of the Legislative Branch, because Congress had failed to provide an intelligible principle governing the SEC’s exercise of its delegated authority; and
3. The statutory removal restrictions on ALJs infringed on the authority of the President by unconstitutionally constraining his supervision of their exercise of the executive power.

For now, the panel decision applies only within the Fifth Circuit. But if adopted more broadly, the decision likely would amount to a death knell for in-house SEC adjudications, at least where the SEC seeks statutory penalties for securities fraud. Although the SEC has traditionally brought civil penalty actions in federal court, the Dodd-Frank Act expanded its authority to adjudicate those matters in-house.² The Fifth Circuit decision strikes down the SEC’s authority and its logic may apply to other agencies as well. Given the potential significance across the administrative state, the panel decision will not be the last word, and the case may well be headed for eventual review by the U.S. Supreme Court.

Background

In this case, the SEC brought an administrative enforcement action, claiming that a hedge fund manager had violated the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 by (i) misrepresenting who served as the prime broker and as the auditor to the funds, (ii) misrepresenting the funds’ investment parameters and safeguards, and (iii) overvaluing the funds’ assets to increase the fees that it could charge investors.

Following an evidentiary hearing, the ALJ found that petitioners had committed securities fraud, which the Commission subsequently affirmed.³ Among other remedies, the SEC ordered a civil penalty of US$300,000 and US$685,000 in disgorgement. The SEC also rejected petitioners’ constitutional challenges, and petitioners filed a petition for review in the Fifth Circuit. In a 2-1 panel opinion, the Fifth Circuit vacated the SEC’s ruling on three independent constitutional grounds.

Seventh Amendment Right To Jury Trial

The Fifth Circuit first held that the SEC’s in-house adjudication violated petitioners’ Seventh Amendment right to a jury trial. The court held that “the Seventh Amendment guarantees [p]etitioners a jury trial because the SEC’s enforcement action is akin to traditional actions at law to which the jury-trial right attaches” and that “Congress, or an agency acting pursuant to congressional authorization, cannot assign the adjudication of such claims to an agency because such claims do not concern public rights alone.” In reaching this conclusion, the decision applied a two-step analysis to determine when Congress may assign adjudications to agency processes that exclude a jury trial.

First, the court analyzed “whether an action’s claims arise ‘at common law’ under the Seventh Amendment.” The court found that civil penalty actions and securities fraud claims were akin to the kinds of actions typically brought at common law, and therefore, petitioners had a right under the Seventh Amendment to have such claims decided by a jury.

Second, the court considered “whether the proceedings center on ‘public rights,’” such that Congress could constitutionally have the matters determined by an agency adjudication without a jury. Looking to Supreme Court precedent, the Fifth Circuit explained that “public rights” are at issue when “Congress passes a statute under its constitutional authority that creates a right so closely integrated with a comprehensive regulatory scheme that the right is appropriate for agency resolution.” The Fifth Circuit rejected the SEC’s argument that, because “the securities statutes are designed to protect the public at large,” the action implicated public rights. The court observed that “Congress cannot convert any sort of action into a ‘public right’ simply by finding a public purpose for it and codifying it in federal statutory law” and that “fraud claims… are quintessentially about the redress of private harms.”

The Fifth Circuit found that “[j]ury trials in securities fraud suits would not ‘dismantle the statutory scheme’ addressing securities fraud or ‘impede swift resolution’ of the SEC’s fraud prosecutions” and that “such suits are not uniquely suited for agency adjudication.” Therefore, the SEC must pursue this action in federal court, where petitioners could exercise their right to a trial by jury.

Non-Delegation Doctrine

The Fifth Circuit next held that the SEC’s statutory discretion to bring enforcement actions either in Article III courts or in administrative adjudications represented an unconstitutional delegation, since Congress had not provided the SEC “with an intelligible principle to guide its use of the delegated power.”

Because Article I of the Constitution provides that “[a]ll legislative Powers herein granted shall be vested in a Congress of the United States,” the Fifth Circuit explained, “Congress may grant regulatory power to another entity only if it provides an ‘intelligible principle’ by which the recipient of the power can exercise it.” In so doing, the Fifth Circuit relied on Supreme Court precedent recognizing that Congress could not delegate to the Executive Branch standardless discretion to impose primary rules of conduct. The Fifth Circuit concluded that Congress’s legislative authority included determining which securities fraud actions for monetary penalties should go forward administratively, yet Congress’ delegation “effectively gave the SEC the power to decide which defendants should receive certain legal processes (those accompanying Article III proceedings) and which should not.” Thus, “[s]uch a decision—to assign certain actions to agency adjudication—is a power that Congress uniquely possesses” and could not constitutionally be delegated to the discretion of the agency.

Statutory Removal Restrictions

Last, the Fifth Circuit held that the statutory removal restrictions for ALJs are unconstitutional under Article II of the Constitution, which obliges the President to “take Care that the Laws be faithfully executed.” The Fifth Circuit relied on the Supreme Court’s recent holding in Lucia v. SEC⁴ that SEC ALJs are “inferior officers” of an executive agency. Because “SEC ALJs perform substantial executive functions,” the President must have “sufficient control over the performance of their functions” and be “able to choose who holds the positions.” The Fifth Circuit held that, by insulating the ALJs from removal, the statutory scheme violated this constitutional protection.

In reaching this conclusion, the Fifth Circuit relied on the Supreme Court’s decision in Free Enterprise Fund v. Public Co. Accounting Oversight Bd.,⁵ which held that the Public Company Accounting Oversight Board (PCAOB) could not constitutionally receive for-cause protection from removal when they could be removed only by SEC Commissioners, who themselves had for-cause protection. The court viewed the tenure protection for ALJs as akin to those for the PCAOB, since SEC ALJs are “insulated from the President by at least two layers of for-cause protection from removal.” SEC ALJs can be removed by the Commission only if good cause is found by the Merits Systems Protection Board (MSPB) and, in turn, SEC Commissioners and MSPB members can only be removed by the President for cause.

Although on one level, the Fifth Circuit’s holding reflects a straightforward application of Free Enterprise Fund, which also involved inferior officers within the SEC, the decision extends that precedent beyond the PCAOB, a regulatory body, to the ALJs responsible for agency adjudications.

Practical Implications and Next Steps

Anti-Fraud Enforcement Moves Back to Federal Courts

The decision in Jarkesy sharply curtails the power of the SEC’s ALJs to adjudicate alleged violations of U.S. securities laws. The court’s holding that the SEC’s enforcement of the anti-fraud provisions of the federal securities laws do not vindicate a “public right” subject to administrative adjudication will significantly affect how the SEC operates. At a minimum, the Fifth Circuit’s decision would appear to bar ALJs from adjudicating securities fraud cases seeking civil penalties, even where the SEC also seeks equitable remedies, such as industry bars and disgorgement. However, the court signaled that the Seventh Amendment’s protection of the jury right might extend further, conceding only that “some actions provided for by the securities statutes may be new and not rooted in any common-law corollary.”⁶ The decision thus leaves open the possibility that ALJs may only have the power to decide non fraud cases that do not involve civil penalties, which would be a rare type of action for the SEC to pursue. If the SEC decides to litigate, it is more likely than not that it will seek penalties should it prevail.

The restriction on the SEC’s ability to seek civil penalties through administrative adjudication would, in some ways, return the Division of Enforcement to its pre-financial crisis authority. Historically, the SEC was obliged to pursue civil penalties in Article III courts, but in 2010, the Dodd-Frank Act granted the Commission the authority to seek civil penalties in administrative proceedings. While the Jarkesy decision likely will put to a halt all SEC administrative adjudications alleging fraud, it is unlikely to impact the SEC’s willingness to litigate a majority of its fraud cases. However, for those more technical fraud cases with little jury appeal, the Commission might seek settlement more often and on potentially better terms for respondents before the SEC.

New Limits on Agencies’ “Unfettered” Enforcement Discretion

The court’s application of the non-delegation doctrine could have even broader implications, since it suggests that the SEC’s unfettered discretion to choose which forum to pursue is unconstitutional. Because the court did not address the remedy for such discretion beyond vacating the commission’s existing action, it leaves open the question of whether the SEC can pursue any non-settled administrative enforcement actions, for fraud or non-fraud securities claims.

The court’s conclusion that the non-delegation doctrine prohibits the SEC from exercising “unfettered discretion” to decide which defendants should be subject to which forum’s processes, could likely be extended more broadly to other agencies with parallel enforcement authority.⁷ In addition, this non-delegation principle may well be applied beyond the enforcement context to other areas where Congress has conferred significant policy discretion on the SEC and other regulators. In relying on Panama Refining Co. v. Ryan, 293 U.S. 388, 405-06 (1935), the Fifth Circuit acknowledged that the Supreme Court has not “in the past several decades” applied the non-delegation doctrine with rigor. In the likely event that the SEC seeks en banc review or certiorari at the Supreme Court, the Commission likely would pay particular attention to the court’s broad non-delegation holding, which could have significant ramifications for the administrative state.

Constitutionality of ALJs Questioned Again

Further, the court’s holding that the statutory removal restrictions for SEC ALJs are unconstitutional is one in a string of recent cases seeking to evaluate ALJs, and more generally the structure of the administrative state, against the constitutional separation of powers. In recent cases, such as Free Enterprise Fund, Seila Law v. Consumer Financial Protection Bureau,⁸ and Collins v. Yellen,⁹ the Supreme Court has emphasized the importance of ensuring a politically accountable President may properly supervise the exercise of executive power.

In 2018, in Lucia, the Supreme Court held that ALJs are “officers of the United States,” and therefore, their appointment by SEC staff, rather than by a constitutionally appropriate appointing authority, was unconstitutional. That trend towards expanding judicial review of structural limitations will likely continue in the Court’s next term. In January 2022, the Supreme Court agreed to hear Axon Enterprise, Inc. v. Federal Trade Commission,¹⁰ which involves the power of a district court to review the constitutionality of the FTC’s structure, and just this month, the Supreme Court added to its docket SEC v. Cochran,¹¹ which presents the similar question of whether district courts may consider constitutional challenges to the SEC’s ALJ framework.¹² In the coming months, the Supreme Court’s decisions will shed additional light on the constitutional challenges to administrative adjudications.

Conclusion

It may be expected that the SEC will likely petition for rehearing en banc of the Fifth Circuit’s decision in Jarkesy, and if it does not convince the en banc court to vacate the panel’s opinion, the Solicitor General is likely to petition for certiorari at the Supreme Court. Until then, respondents within the Fifth Circuit may rely heavily on this decision as a defense to any adverse administrative decisions within the SEC, and respondents outside the Fifth Circuit will similarly seek to capitalize upon the arguments that proved successful in Jarkesy. Whatever the ultimate resolution, the Fifth Circuit’s decision is likely to make it much more difficult in the near-term for the SEC to rely on in-house adjudicators, rather than federal courts, for most kinds of enforcement actions.

Footnotes

1. No. 20-61007.
2. See 15 U.S.C. § 78u-2(a).
3. While the petitioners’ case was pending review before the SEC following an adverse decision by the ALJ, the Supreme Court held that SEC ALJs were officers of the United States and had to be appointed by the Commission. Lucia v. SEC, 138 S. Ct. 2044, 2054–55 (2018). In accordance with Lucia, the SEC assigned the case to a properly appointed ALJ. However, petitioners waived their right to a new hearing and continued to pursue review by the Commission under their original petition.
4. 138 S. Ct. 2044 (2018). For further information regarding the Lucia decision, please refer to the Dechert OnPoint from 2018.
5. 561 U.S. 477, 498 (2010).
6. Emphasis added.
7. The decision could have significant ramifications for, inter alia, the Commodity Futures Trading Commission and the Federal Trade Commission (FTC), which enforce their statutes administratively and in Article III courts.
8. 140 S. Ct. 2183, 2191 (2020).
9. 141 S. Ct. 1761, 1784 (2021).
10. 986 F.3d 1173 (9th Cir. 2021), cert granted in part, 142 S. Ct. 895 (Mem.) (U.S. Jan. 24, 2022) (No. 21-86).
11. 20 F.4th 194 (5th Cir. 2021), cert granted, 2022 WL 1528373 (U.S. May 16, 2022) (No. 21 1239).
12. A similar issue arose in Jarkesy when petitioners initially sued in the United States District Court for the District of Columbia to enjoin the SEC’s administrative proceedings on constitutional grounds. The Court of Appeals for the District of Columbia circuit ultimately dismissed that challenge, ruling that Congress’ established scheme of SEC administrative proceedings followed by court of appeals review precludes petitioners from seeking review by a district court in the first instance. 803 F.3d 9, 12 (D.C. Cir. 2015).