SEC’s In-House Adjudication Deemed Unconstitutional by Fifth Circuit

A key enforcement power of the Securities and Exchange Commission (“SEC”)—its ability to elect to conduct in-house administrative proceedings before Administrative Law Judges (“ALJs”) instead of bringing an action in federal court—is unconstitutional, according to a recent opinion by the United States Court of Appeals for the Fifth Circuit.[1] The decision is part of a larger trend of recent cases challenging SEC activity on constitutional grounds, and could spell a dramatic shift in the way SEC enforcement actions, and administrative agency proceedings in general, are conducted.

Background on SEC Administrative Proceedings

One of the SEC’s functions is to bring enforcement proceedings against those alleged to have violated securities laws, such as the Securities Act of 1933, Securities Exchange Act of 1934, or Investment Advisor Act of 1940. The SEC may do so either by filing a case in federal district court, subject to all Federal Rules of Civil Procedure and Evidence and providing a right to jury trial, or, alternatively, by proceeding in-house where court rules of procedure and evidence, and right to a jury, do not apply, and the initial, de novo appeal is made to the Commission itself (and only then appealable to a federal Court of Appeals).[2]

In the SEC’s early years, it could bring administrative proceedings only against certain “regulated” entities seen as having consented to such proceedings, such as broker-dealers, and even then only to pursue remedial remedies.[3] With the Penny Stock Reform Act of 1990, the SEC was authorized by Congress to impose punitive sanctions in administrative proceedings, again only against certain entities directly regulated by the SEC such as broker-dealers (with civil penalties against non-regulated entities to be brought only in federal court).[4] But following criticism that the SEC failed to prevent the 2008 financial crisis, Congress passed the Dodd-Frank Act in 2010, which among other things dramatically expanded the SEC’s power to bring administrative proceedings seeking civil penalties—even against non-regulated entities and individuals.[5]

Through the Dodd-Frank Act, Congress provided the SEC with wide discretion to elect to bring actions as in-house proceedings before an ALJ rather than through a federal district court, without a need to provide any explanation for its choice of forum.[6] In 2013 the SEC staff announced that it would rely more heavily on administrative procedures.[7] Since that time, the SEC’s preference to pursue proceedings in-house has been plain; indeed, a 2021 analysis of SEC enforcement actions against public companies found that in the previous five fiscal years an average of 89% of such actions were brought as administrative proceedings rather than through federal district courts.[8]

There has long been criticism of SEC Administrative Proceedings. For example, criticism that the SEC would develop its case at length prior to commencing an action only to impose tight deadlines on defendants after commencing the administrative proceeding led to amendments to the SEC’s Rules of Practice relaxing these deadlines.[9] In addition, data shows that the SEC enjoys a significant “home court advantage,” finding more success in administrative proceedings than it had previously found in federal court.[10] Constitutional challenges to Administrative Proceedings have abounded in appellate courts for years, with appellants, largely unsuccessfully, arguing that administrative proceedings violate various due process or equal protection rights.[11] The Fifth Circuit’s decision in Jarkesy, discussed below, is the biggest blow to date.

The Fifth Circuit Rules SEC Administrative Proceedings Unconstitutional

On May 18, 2022, the Fifth Circuit, in a 2-1 decision, vacated an ALJ decision granting hundreds of thousands of dollars in penalties and disgorgement on constitutionality grounds. In particular, the Court found that SEC Administrative Proceedings were unconstitutional in three, independent, respects: first, that Petitioners were deprived of their constitutional right to a jury, second, that Congress unconstitutionally delegated legislative power to the SEC, and third that the statutory removal restrictions on SEC ALJs violated Article II of the Constitution.[12]

Right to a Jury

The Court found that the SEC’s Administrative Proceedings violated the Seventh Amendment right to a jury trial because an SEC enforcement action is “akin to traditional actions at law to which the jury-trial right attaches,” rejecting the SEC’s argument that the proceedings only involved “public rights” of the sort which Congress is permitted to assign to administrative adjudication without a jury, that is, rights created by statutes within the power of Congress to enact.[13] The Court found that the rights sought to be vindicated were not public rights, but rather was akin to fraud actions brought in English courts under common law for centuries and the fact that the securities statutes were “designed to protect the public at large,” does not convert the action into a “public right.”[14] The Court also held that the equitable remedies sought by the SEC in addition to the monetary penalties did not allow it to avoid a jury trial.[15]

Unconstitutional Delegation of Power

In addition to constitutional violations of the right to a jury trial, the Court also found that the SEC in-house administrative proceedings were unconstitutional because Congress provided the SEC with the “unfettered authority to choose whether to bring enforcement actions” in federal court or as Administrative Proceedings.[16] The Court explained that the accountability sought by the founders through the legislature “evaporates” if an entity other than Congress exercises legislative power, and held that by granting the SEC the power to choose how to bring its actions without any “intelligible principle” for making that determination Congress unconstitutionally delegated its legislative powers to the SEC.[17] The Court rejected the SEC’s analogy to “prosecutorial discretion,” noting that Congress did not only give the SEC the power to decide whether to bring an enforcement action, but rather “effectively gave the SEC the power to decide which defendants should receive certain legal processes[.]”[18] These legal processes, e.g. a right to a jury trial, are often not available in administrative proceedings.[19]

Statutory Removal of ALJs

Finally, the Court found a third “constitutional infirmity,” with the SEC administrative proceedings relating to the layers of for-cause protection preventing the removal of ALJs by the President of the United States and thus impeding the Executive branch’s control over the ALJs as guaranteed by Article II of the United States Constitution.[20]

The Dissent

The dissent disagreed with all three constitutional infirmities identified by the majority, agreeing instead with the SEC’s arguments on each point. In particular, the dissent agreed with the SEC that a jury trial was not required for SEC enforcement actions as such actions involve protection of “public rights” created by Congressional statute, and are “not identical” to common law fraud claims.[21] The dissent also concluded that Congress permissibly delegated the selection of court or agency proceedings to the SEC, analogizing to Supreme Court precedent permitting prosecutorial discretion of which crimes to bring.[22] Finally, the dissent concluded that the Constitution does not expressly prohibit removal protections for Officers of the United States and as a result the for-cause protections from removal are not unconstitutional.[23]

Significance and Next Steps

The Fifth Circuit’s decision is highly significant, and could, if upheld in further appeals of this case, present a sea change in how SEC enforcement actions are brought. As discussed above, at present the SEC has demonstrated a strong preference for bringing enforcement actions in-house, which critics contend provides it with a distinct advantage it would not otherwise have in federal court. If the SEC is unable to secure this advantage, and instead forced to bring actions in federal civil court only, it may be hampered in its enforcement priorities. For example, the SEC has made clear that it intends to aggressively pursue ESG-related misconduct with the formation last year of a “Climate and ESG Task Force,”[24] which has already seen at least one large fine levied following an administrative proceeding. Moreover, much of the Fifth Circuit’s opinion could be argued to apply to other agencies’ administrative proceedings that are similar to the SEC’s, with the potential to determine that multiple agencies’ procedures are unconstitutional going forward. In light of this case’s significance, it will likely be presented to the Fifth Circuit en banc, and may eventually reach the United States Supreme Court. The repercussions of a Supreme Court opinion on this topic, especially one affirming the result and adding additional commentary critical of administrative law proceedings more generally, has the potential to change the shape of administrative law enforcement in this country greatly.

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[1] Jarkesy v. Sec. & Exch. Comm'n, No. 20-61007, 2022 WL 1563613 (5th Cir. May 18, 2022), https://www.ca5.uscourts.gov/opinions/pub/20/20-61007-CV0.pdf.

[2] Joseph A. Grundfest, Fair or Foul?: SEC Administrative Proceedings and Prospects for Reform Through Removal Legislation, 85 Fordham L. Rev. 1143 (2016), https://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=5265&context=flr.

[3] Stephen J. Choi and A.C. Pritchard, The SEC's Shift to Administrative Proceedings: An Empirical Assessment, 34 Yale Journal on Regulation 1, 6-7 (Winter 2017), https://openyls.law.yale.edu/bitstream/handle/20.500.13051/8243/Choi_stephen.pdf?sequence=2&isAllowed=y.

[4] Id. at 7.

[5] Id. at 9.

[6] Jarkesy, supra n.1, at 23 (citing 15 U.S.C. § 78u-2(a)).

[7] Grundfest, supra n. 2 at 1146.

[8] See Cornerstone, SEC Enforcement Activity: Public Companies and Subsidiaries, Fiscal Year 2021 Update at 5, https://www.cornerstone.com/wp-content/uploads/2021/12/SEC-Enforcement-Activity-FY2021-Update.pdf.

[9] Choi, surpa n. 3 at 14.

[10] See Ryan Jones, Comment, The Fight over Home Court: An Analysis of the SEC's Increased Use of Administrative Proceedings, 68 SMU L. Rev. 507, 519 (2015), https://scholar.smu.edu/cgi/viewcontent.cgi?article=1031&context=smulr; see also Alexander I. Platt, SEC Administrative Proceedings: Backlash and Reform, 71 Bus. Law. 1 (2016), https://ccl.yale.edu/sites/default/files/files/Platt%20-%20SEC%20Administrative%20Proceedings(1).pdf.

[11] Jones, supra n. 10 at 523-528. Notably, success was had in challenging the appointments process for ALJs, with the United States Supreme Court ruling in 2018 that ALJs were “Officers of the United States” and must be appointed pursuant to the Appointments Clause of the Constitution. See Lucia v. S.E.C., 138 S. Ct. 2044, 2049, 201 L. Ed. 2d 464 (2018).

[12] Jarkesy, supra n.1, at 4.

[13] Id. at 5, 8.

[14] Id. at 9, 11, 14.

[15] Id. at 10-11.

[16] Id. at 18.

[17] Id. at 20-22.

[18] Id. at 22-23 (emphasis in original).

[19] See Grundfest, supra n. 2 at 1144-45.

[20] Jarkesy, supra n.1 at 25-26.

[21] Id. at 37 (Davis, J., dissent).

[22] Id. at 45.

[23] Id. at 47-54.

[24] Press Release, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (March 4, 2021), https://www.sec.gov/news/press-release/2021-42.