The SEC (and Other Agencies) Could Lose a Powerful Enforcement Tool
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The SEC (and Other Agencies) Could Lose a Powerful Enforcement Tool

Brownstein Client Alert, July 12, 2023

The U.S. Supreme Court will decide whether the use of administrative law judges passes constitutional muster

If the U.S. Supreme Court upholds a recent Fifth Circuit ruling, it could end the use of administrative proceedings by agencies like the United States Securities and Exchange Commission (SEC). This would be a decided victory for private plaintiffs and add significant costs to the SEC’s enforcement agenda. It may even mean the SEC will stop seeking certain forms of relief because the alternative path of litigation is too time- and resource-intensive.

Overview of SEC’s Administrative Process

The SEC enforces U.S. securities law in two ways: first, it may institute administrative enforcement proceedings seeking civil penalties, cease-and-desist orders and other remedies.1 In the alternative, the SEC can bring civil actions in federal district court seeking an injunction, penalties and other remedies.2

If the SEC takes the administrative proceeding route, it assigns the proceeding to an administrative law judge (ALJ).3 ALJs are part of the executive branch, not the judicial branch, and are appointed by the heads of the executive agencies. ALJs then receive evidence, hold hearings, hear arguments and issue an initial decision.4 Either party may appeal the ALJ’s decision to the SEC, and the SEC will then review the decision on its own initiative.5 If the SEC’s final order in the adjudication is adverse to the respondent, that party may obtain judicial review by filing a petition in a court of appeals.6 Despite being part of the executive branch, an ALJ is relativity insulated from oversight and can only be removed for “good cause.”7

Background of Jarkesy

SEC v. Jarkesy has a long history at this point. George Jarkesy launched two hedge funds with his advisory firm, respondent Patriot28, L.L.C., serving as the funds’ investment adviser, with allegedly $24 million in assets. The SEC alleged that Jarkesy made misrepresentations to the funds’ 120 investors in three ways. First, the fund represented that an accounting firm was auditing the fund, but the firm never did. Second, the fund misrepresented its investment strategy by, for example, telling investors that one fund would invest 50% of its capital into life insurance policies, which are relatively safe, but less than 20% of its capital was invested in those policies. And third, the funds were overvalued sometimes by as much as 100%.

Way back in 2013, the SEC brought an administrative proceeding against Jarkesy and the fund. In turn, Jarkesy and the fund sued the SEC, seeking to enjoin the agency adjudication on constitutional grounds. The district court dismissed the lawsuit, which the D.C. Circuit Court affirmed, finding that the respondents had to wait until after the SEC’s adjudication to assert a constitutional challenge. Eventually, an ALJ found Jarkesy and the fund liable and ordered them to pay $684,935 in disgorgement, $300,000 as a civil penalty, and to cease and desist future violations. Jarkesy and the fund appealed.

Petition to U.S. Supreme Court

In May last year, the Fifth Circuit Court of Appeals (overseeing federal district courts in Louisiana, Missouri and Texas) ruled that the SEC’s use of the ALJ violated three constitutional provisions: the right to a trial by jury, the Nondelegation Doctrine and the Take Care Clause. Specifically, the appellate court found that by delegating authority to an agency to seek civil penalties, the SEC’s process violates the Seventh Amendment’s protections, including the right to trial by jury. The court further found that the SEC’s administrative process violates the Nondelegation Doctrine by holding that Congress cannot delegate its rulemaking authority to an administrative agency. Finally, the court found the administrative proceedings violate Article II of the U.S. Constitution by granting for-cause removal protection to administrative law judges.

The U.S. Supreme Court granted certiorari on all three issues.

Potential Consequences Could be Broad

If the U.S. Supreme Court upholds the Fifth Circuit’s decision, the SEC and other administrative agencies may need to file all future actions in federal court. Further, any and all current actions before an administrative law judge could be in jeopardy. The Social Security Administration, U.S. Department of Labor and U.S. Department of Health and Human Services, for example, all rely to some level on administrative law judges and could also be impacted by the decision.

Given the current makeup of the U.S. Supreme Court, several of its recent opinions, including Lucia v. SEC, 138 S. Ct. 2044 (2018), and its reputation for hostility toward the use of administrative proceedings, the SEC may be fighting an uphill battle. Specifically, the Supreme Court opined in Lucia that the ALJs were “inferior officers” and had to be appointed through the president or a designee. After the Lucia decision, the SEC had to go through the time-intensive process of reviewing all previous ALJ orders and offering respondents an opportunity to relitigate their actions. Notably, the same option was offered to Jarkesy, who refused.

In the meantime, we expect the SEC will be reticent in using ALJ proceedings for cases of fraud. This in turn may create additional delays in the SEC’s enforcement actions, especially those that are not resolved pre-litigation. For SEC actions that are not dismissed or settled, a Jarkesy opinion affirming the Fifth Circuit may also mean that the SEC will be even more aggressive in its district court actions against respondents than it would have otherwise been in an ALJ proceeding. This in turn could be a lose-lose for the SEC and private plaintiffs and may only stand to benefit Jarkesy and his funds.

And in the end, taxpayers will be responsible for paying for more expensive and time-consuming proceedings in federal district court across all agencies—especially considering that a congressional “fix” to allow the use of AlJs appears unlikely at this time (if possible at all).

1 15 U.S.C. 77h-1, 78u-2, 78u-3, 80b-3

2 15 U.S.C. 77t, 80b-9; 15 U.S.C. 78u(d) (2018 & Supp. II 2021).

3 15 U.S.C. 78d-1(a); 17 C.F.R. 200.30-9

4 17 C.F.R. 201.221-201.360

5 17 C.F.R. 201.410(a), 201.411(c)

6 15 U.S.C. 78y(a)(1)

7 5 U.S.C. 7521(a)

This document is intended to provide you with general information regarding SEC v. Jarkesy. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.

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