SCOTUS Limits the SEC’s Ability To Use In-House Tribunals To Seek Civil Penalties For Securities Fraud, Stripping the Agency of One of Its Many Enforcement Tools

KEY TAKEAWAYS

• The Seventh Amendment precludes the SEC from using in-house adjudications for enforcement actions seeking civil penalties.
• The SEC must bring future enforcement actions seeking civil penalties before Article III federal courts.
• The decision is likely to extend to other agencies seeking civil penalties for similar claims.

SUMMARY

Yesterday, the Supreme Court handed down its decision in SEC v. Jarkesy, holding that the Seventh Amendment entitles defendants to a jury trial in an Article III court when the SEC seeks civil penalties for securities fraud. The decision was split 6-3, with Chief Justice John Roberts writing for the conservative majority. This decision is one of several this term sharply limiting the power of federal administrative agencies.

SEC Background

Historically, the SEC could bring an enforcement action in one of two ways: it could file suit in federal court, or it could adjudicate the matter in one of its in-house tribunals. The SEC’s choice of forum dictated certain aspects of the litigation. If the enforcement action was brought in an Article III federal court, the defendant could demand a trial by jury, and ordinary rules of discovery and the Federal Rules of Evidence would govern the litigation. But if the SEC chose to adjudicate the matter in-house, no jury would be available; the dispute would be adjudicated before the Commission itself or a designated Administrative Law Judge (ALJ), and the SEC’s Rules of Practice would govern the finding of facts and discovery disputes. These in-house ALJs are appointed by the SEC and can be removed only for “good cause established and determined by the Merit Systems Protection Board,” whose three members are appointed by the President and can be removed “only for inefficiency, neglect of duty, or malfeasance in office.”

Case Background

Shortly after Dodd-Frank’s passage, the SEC brought an administrative proceeding against George Jarkesy, founder of two hedge funds with roughly 120 investors and $24 million in assets. The SEC assigned the proceeding to an ALJ, who found that Jarkesy violated the anti-fraud provisions of the securities laws. Jarkesy was eventually ordered to pay a civil penalty of $300,000. His advisory firm, Patriot28, also had to repay nearly $685,000 in what the SEC determined were illicit gains. After the SEC adopted the ALJ’s decision as its final order, Jarkesy appealed to the Fifth Circuit. A divided panel vacated the SEC’s order on three separate constitutional grounds: (1) the SEC’s proceedings violated the Seventh Amendment right to a jury trial; (2) it was improper for Congress to allow the agency to decide which cases could proceed using internal tribunals; and (3) the ALJs’ “for-cause” protection from removal was unconstitutional. The SEC appealed the Fifth Circuit’s decision to the U.S. Supreme Court, which granted certiorari to review all three grounds.

Majority Opinion

Chief Justice Roberts, writing for the Court, found that the Seventh Amendment entitles a defendant to a jury trial when the SEC seeks civil penalties for securities fraud. The Seventh Amendment guarantees that in “[s]uits at common law . . . the right of trial by jury shall be preserved.” Relying heavily on the Court’s previous decisions in Granfinanciera, S.A. v. Nordberg (1989) and Tull v. United States (1987), the Court explained that the SEC’s antifraud provisions replicate common-law fraud claims, which typically must proceed before Article III courts.

The Court reasoned that the factors adopted in Granfinanciera necessitated a finding that the SEC action involved a “common law” claim, so the right to a jury trial had to be preserved. The Court also relied on Tull to emphasize that the SEC sought civil penalties for the alleged fraud, a form of monetary relief that would require a trial by jury if found to be “legal” in nature (as opposed to “equitable”). The Court found the monetary relief sought by the SEC to be legal in nature because it was designed to punish and deter fraud, rather than simply “restore the status quo.” Thus, the Court concluded that penalties are “a type of remedy at common law that could only be enforced in courts of law.” Id.

The Court rejected the SEC’s argument that Granfinanciera did not apply merely because the Government is the party bringing the action. Instead, the Court reaffirmed the principle that, “[w]hat matters is the substance of the suit, not where it is brought, who brings it, or how it is labeled.” And the Court distinguished its prior decision in Atlas Roofing (1977), which involved civil penalties imposed by OSHA for violating workplace safety violations. The Court reasoned that the claims in Atlas Roofing were statutory in nature and did not borrow from the common law-based securities laws.

The Court also confirmed its conclusion by examining the “close relationship” between federal securities fraud and common-law fraud. The Court noted that both address the same basic conduct (misrepresenting or concealing material facts) and explained that Congress deliberately used the word “fraud” and other common law “terms of art” in enacting the federal securities laws, incorporating common-law fraud prohibitions.

Chief Justice Roberts also explained why the “public rights” exception recognized many years ago in Murray’s Lessee v. Hoboken Land & Improvement Co. (1856) did not apply to SEC enforcement actions. Having concluded that enforcement actions were suits “in the nature of an action at common law,” the Chief Justice applied the principles elucidated in the more recent decision, Stern v. Marshall (2011), to find that this matter “presumptively concerns private rights” and that adjudication by an Article III court was required.

As for the remaining issues–the delegation in the Dodd-Frank Act and the removal protections for the SEC’s ALJs—the Court left them to be addressed in future cases.

Sotomayor Dissents

Justice Sotomayor dissented, joined by Justices Kagan and Jackson. The main thrust of the dissent is that the Court appears to contradict prior decisions holding that “Congress has broad latitude to create statutory obligations that entitle the Government to civil penalties, and then to assign their enforcement outside the regular courts of law where there are no juries.” The dissent also asserts that the majority’s decision reflects the “Court’s repeated failure to appreciate that its decisions can threaten the separation of powers” and that the Court “oversteps its role and encroaches on Congress’s constitutional authority” by holding that “Congress . . . cannot entrust certain public-rights matters to the Executive because it must bring them first into the Judiciary’s province.”

WHAT THIS MEANS

Despite its sweeping language, the Court’s ruling yesterday may be narrower than it initially may seem. As noted, the Court came to a decision on only one of the three constitutional issues raised, and the result is ultimately more constrained than the Fifth Circuit’s decision. By resolving this case on only the Seventh Amendment issue, the Court likely limited the practical impact on the SEC’s enforcement strategy. The decision today preserves much of what SEC enforcement is currently doing in practice and what it has noted that it plans to focus on in the coming year. Since the Court’s 2018 decision in Lucia v. SEC, the Commission has largely litigated its securities fraud cases seeking civil penalties in federal district court. Moreover, the large arsenal of remedies in the SEC’s toolkit that are untouched by yesterday’s decision remain available in in-house tribunals. Still, the decision may have a broader effect on other federal agencies that also impose civil penalties through in-house adjudications. And the Court is likely to revisit the remaining issues, particularly the constitutionally of the SEC’s ALJs, in a future case.