The discretion of the Securities and Exchange Commission to use its own in-house judges to hear cases was dealt a body blow on May 18 by the U.S. Court of Appeals for the Fifth Circuit. That Court determined that defendants in such cases are deprived of their Seventh Amendment right to a jury trial, and that Congress’s delegation of that discretion was unconstitutional because it was not accompanied by any “intelligible principle by which the SEC could exercise the delegated power.”
The Dodd-Frank legislation enacted in 2010 gave the SEC the unfettered right to determine whether to bring securities fraud actions for monetary penalties against non-registrants in either its in-house tribunals or in Article III courts. It has bothered many in the securities enforcement defense bar that the agency’s determination as to where to proceed was a proverbial black box. Securities defense counsel has had a lot of experience in trying to persuade the agency to exercise its discretion to reduce charges or to not bring charges at all, but why the Commission chose a particular tribunal was often a mystery. For the most part, prospective defendants typically preferred the protections of federal court proceedings rather than the home turf of the agency’s administrative judges.
While earlier litigation had challenged the authority of the SEC’s administrative law judges to hear these kinds of cases based on how they were appointed (and resulted in changes to the appointment process), the Fifth Circuit decision in Jarkesy v. SEC is the first Circuit to determine that these administrative proceedings violated a defendant’s right to a jury trial. In that case, George Jarkesy established two hedge funds and appointed Patriot28 as the investment advisor. At their peak, the funds held about $24 million in assets. The Commission brought charges against Jarkesy and Patriot28 (“petitioners”) in its own tribunal, alleging that they made misrepresentations to investors and overvalued the funds’ assets to inflate the fees they could charge. In finding against the petitioners, the ALJ held that they committed securities fraud, and ordered that they pay a civil penalty of $300,00 and disgorge $685,000, a ruling which was affirmed by the Commission. The Commission also rejected several challenges raised by the petitioners, determining, inter alia, that the Commission did not use unconstitutionally delegated legislative power, did not violate separation of powers principles, and did not abridge the petitioners’ Seventh Amendment right to a jury trial.
Jarkesy and Patriot28 appealed the Commission’s decision to the Fifth Circuit, which overturned the SEC’s judgment based on two independent rationales. With respect to the Seventh Amendment right to a jury trial, the Court rejected the SEC’s argument that its claims constituted distinctly “public rights” created by statute. Public rights, according to the U.S. Supreme Court, are created by statute where the right is closely integrated with a comprehensive regulatory scheme such that the right is appropriate for agency adjudication. Securities fraud claims, the Circuit reasoned, are analogous to fraud claims that have long been brought under common law. The Court expounded at length on the importance the Founding Fathers placed on jury trials as a check on government authority and noted that the SEC had brought many cases before juries in federal courts. Thus, the enforcement of securities fraud law is not so integrated with a comprehensive regulatory scheme such that requiring the SEC to proceed before juries would disrupt that enforcement. Defendants are therefore entitled to a jury trial in federal court when they are faced with securities fraud claims in which penalties are sought.
The second basis the Fifth Circuit identified for overturning the SEC’s decision was that Congress had unconstitutionally delegated its power to select a forum for enforcement by permitting the agency to have the discretion to choose that forum. While Congress can permit discretion to an agency, that discretion must have some “intelligible principle” for its exercise. The Court found that there was no such principle in the statute and rejected the SEC’s argument that the forum selection decision was simply another form of prosecutorial discretion. While the agency has the discretion to decide whether and what to charge, the Court found that the discretion at issue here implicated the procedural rights afforded to a defendant.
We likely have not seen the end to these issues being litigated in the courts, not only in SEC enforcement actions, but also in other administrative enforcement schemes. As a Fifth Circuit decision, this case constitutes precedent for cases in its jurisdiction of Texas, Louisiana and Mississippi. The SEC could well decide to seek a rehearing en banc to the full appellate court or seek certiorari review in the U.S. Supreme Court, and, of course, other circuit courts will also weigh in when these issues come before them. What is certain is that expansion of the reasoning of Jarkesy to other administrative enforcement schemes is sure to follow and may stymie the efforts of agencies like the Federal Trade Commission and the Commodity Futures Trading Commission that bring many of their cases before administrative law judges.
 Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 54 (1989)