Is the SEC’s internal judicial system in danger?

When the Securities and Exchange Commission decides to pursue a lawsuit against a company or individual, it has two options: file a lawsuit in federal court, where defendants have all the usual procedural protections, or initiate an administrative proceeding. .

In an administrative proceeding, the SEC is not only the prosecutor, but also serves as judge and jury. These internal proceedings take place before Administrative Law Judges (ALJs), who are appointed by the SEC. And the SEC has historically won business at a much higher rate in these proceedings.
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ALJs have extremely broad powers, including the power to impose penalties and permanently bar people from the industry. This includes banning CPAs and securities attorneys from practicing before the SEC.

The defendants have always opposed this system, arguing that it is both unfair and unconstitutional. These arguments are now finding ground in the courts.

Jarkesy vs. SEC is one of the most significant developments in this field. The May 18 ruling by the United States Court of Appeals for the Fifth Circuit significantly limits the SEC’s use of administrative procedures and may signal a fundamental shift in the way cases are handled by the SEC, which could benefit defendants.

The Jarkesy Decision

The SEC has initiated internal enforcement proceedings against George R. Jarkesy Jr. and his consulting firm Patriot28 LLC for allegedly misrepresenting the assets and operations of two hedge funds. Jarkesy sought to have the suits barred, arguing they violated his constitutional rights, but his efforts failed in federal court.

The ALJ and SEC ultimately concluded that Jarkesy and Patriot28 committed securities fraud, resulting in civil penalties, reimbursement, and an industry bar. The call to the Fifth Circuit followed.

A divided Fifth Circuit ruled that the SEC’s internal court system was unconstitutional in its current form and that the proceedings violated Jarkesy’s Seventh Amendment right to a jury trial.

The court also ruled that Congress had “unconstitutionally delegated legislative power” to the SEC when it gave “no advice whatever” as to when the SEC should initiate an administrative proceeding rather than filing a lawsuit in federal court. Finally, the court found that the SEC’s ALJs were too far removed from the president’s removal, violating the separation of powers.

Impact of the decision

The importance of Jarkesy The decision cannot be overstated, and for this reason, the SEC on July 1 asked the entire Fifth Circuit to reconsider the decision. Depending on the outcome of the petition, the commission could also seek review by the U.S. Supreme Court.

If the Jarkesy decision stands, it could lead to fundamental changes in the way the SEC has operated for decades. After Lucia c. DRYwhich ruled that the commission’s ALJs were unconstitutionally appointed, the SEC began taking the bulk of its contested enforcement actions to federal court.

Whether Jarkesy were to become the law in other circuits, what might have been a temporary stint in federal court could become permanent, given the continued success of defendants in challenging administrative proceedings.

Just two days before Jarkesy has been decided, the Supreme Court has agreed to hear the SEC’s appeal of Cochran v SECwhich allowed defendants to go to federal court first to challenge the constitutionality of the SEC’s internal court system rather than forcing defendants to undergo a full administrative process and appeal to the commission before doing so.

If the Supreme Court confirms Cochran, defendants will be able to expedite their constitutional challenges. Even before that, the combined impact of Cochran and Jarkesy will likely encourage defendants to take their challenges to federal court.

And after?

With courts now willing to consider existential challenges to SEC administrative proceedings, this could signal a major shift in how SEC enforcement actions are pursued and resolved.

While waiting for the various appeals to be resolved, defendants still run the risk of defending themselves against claims brought before what at least one court has ruled to be an unconstitutional system.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Susan E. Hurd is a partner in the Securities Litigation Group of Alston & Bird. She represents companies and their executives in securities class action lawsuits, derivatives cases, merger litigation and SEC investigations.

Matthew E. Newman is a senior partner in Alston & Bird’s Securities Litigation Group, specializing in complex securities litigation, SEC and DOJ investigations, and regulatory and compliance matters.