The SEC’s enforcement regime may soon undergo a constitutional revamp

December 2022  |  SPECIAL REPORT: WHITE-COLLAR CRIME

Financier Worldwide Magazine

December 2022 Issue

The Securities and Exchange Commission (SEC) has two enforcement options to police the securities markets. It can commence either a civil action in federal court or an in-house administrative proceeding. It can then either adjudicate the administrative proceeding itself or, as is more common, delegate adjudication to one of its five administrative law judges (ALJs).

These two enforcement options differ in procedural features, frequency and outcome. Discovery practice is streamlined and evidentiary rules are relaxed in administrative proceedings. Respondents also generally cannot make pretrial dispositive motions. The Dodd-Frank Act empowered the SEC to impose civil monetary penalties and complete industry bars in administrative proceedings against non-regulated parties, making the agency’s available remedies in federal court and administrative proceedings essentially coextensive. The SEC’s use of administrative proceedings vis-à-vis civil actions markedly increased.

And understandably so. The SEC has significant advantages in its own courts. An SEC-appointed ALJ adjudicates the case, which gets heard on appeal by the SEC commissioners who voted to commence the administrative proceeding in the first place. The SEC is the plaintiff, judge and appellate court. The SEC defends this regime on expertise and efficiency grounds.

Practitioner criticisms of the SEC’s home court advantage and the US Supreme Court’s recent attention to the administrative state spurred litigants to bring constitutional challenges to various aspects of the SEC’s enforcement regime.

A few years ago, the Supreme Court addressed one constitutional issue relating to SEC ALJs in Lucia v. SEC (2018). The Supreme Court there held that SEC ALJs are constitutional “inferior officers” – not mere civil servants – that therefore could not be selected by SEC staff members without the approval of SEC commissioners. The court observed that SEC ALJs exercise authority comparable to federal court judges: SEC ALJs take testimony, conduct trials, and make evidentiary and discovery rulings. After these adversarial proceedings, SEC ALJs issue initial decisions with factual findings and legal conclusions, which SEC commissioners can then adopt as final decisions of the agency without further review.

While Lucia ruled that the appointment process of SEC ALJs was constitutionally infirm, it did not reach the inverse issue regarding the constitutionality of the removal process for SEC ALJs. SEC ALJs can be removed only by the SEC commissioners if good cause is found by the Merits Systems Protection Board (MSPB). In turn, the president can only remove MSPB members and the SEC commissioners for good cause. If SEC ALJs perform executive functions, these two layers of for-cause removal protection arguably unconstitutionally insulate the SEC ALJs from accountability to the chief executive – the president (see Free Enter. Fund v. Public Co. Acct. Oversight Board (2010)).

After Lucia, the SEC remanded all pending administrative proceedings to proceed before new and properly appointed ALJs. But Michelle Cochran, a certified public accountant, did not wait for her administrative proceeding before a new ALJ to run its course. Ms Cochran, who allegedly violated federal auditing documentation requirements, petitioned a federal court to enjoin her pending administrative proceeding based on the removal issue Lucia did not reach.

Ms Cochran’s pre-enforcement constitutional challenge was arguably premature. Every appellate court to consider the question had interpreted the ‘jurisdiction-stripping’ section 78y of the Exchange Act to require respondents like Ms Cochran to wait until the SEC issues a final adverse order before bringing a collateral constitutional challenge to an administrative proceeding in federal court. And even then, such a challenge could be brought only in a federal court of appeals, not a federal district court. Accordingly, the district court ruled that it lacked jurisdiction over Ms Cochran’s case, and a Fifth Circuit appellate panel affirmed.

But after an en banc rehearing of Ms Cochran’s case, the Fifth Circuit reversed course and held that she could immediately press her constitutional claims (Cochran v. SEC (2021)). Among other rationales, the Fifth Circuit reasoned that the Exchange Act’s jurisdiction-stripping provision cannot preclude redress for the injury of being brought into an administrative proceeding conducted by a potentially unconstitutionally unaccountable ALJ. And Ms Cochran’s constitutional claims were outside the SEC’s agency expertise. The SEC has expertise in securities, not constitutional claims.

The en banc Fifth Circuit court did not reach the merits of Ms Cochran’s removal power claim. The Supreme Court granted the SEC’s petition for certiorari and will hear her case.

Cochran expanded when and where respondents can constitutionally challenge SEC administrative proceedings. The Fifth Circuit’s latest rebuke of the SEC’s enforcement regime in Jarkesy v. SEC (2022) expanded what constitutional challenges have merit.

George Jarkesy and his advisory firm Patriot28 launched two hedge funds that attracted about 120 investors and held about $24m in assets under management. The SEC’s final order rejected Mr Jarkesy’s constitutional challenges and affirmed that Mr Jarkesy misrepresented the identity of the funds’ auditor and prime broker and the funds’ investment parameters and safeguards and also overvalued the funds’ holdings to increase management and performance fees. The SEC imposed a $300,000 civil penalty on Mr Jarkesy and Patriot28, barred him from the securities industry, and ordered Partriot28 to disgorge about $685,000 in ill-gotten gains.

Upon review, a divided Fifth Circuit panel held that Mr Jarkesy’s administrative proceeding was constitutionally defective in three independent ways and vacated the SEC’s final order.

First, administrative agencies like the SEC can adjudicate public rights created by federal statutes without juries. Traditional public rights include disputes over public benefits and employment. Yet the rights under the securities laws that the SEC adjudicated ‘reflected’ common law fraud. Mr Jarkesy consequently had a Seventh Amendment right for a jury to determine the civil monetary penalties.

Second, Congress did not give the SEC an ‘intelligible principle’ in the Dodd-Frank Act to guide the agency’s ‘unfettered’ authority in deciding which enforcement option to use against an alleged wrongdoer. The court observed that the SEC effectively chooses which alleged wrongdoers enjoy certain legal processes in federal court and which do not – an unconstitutional delegation of legislative power by Congress to the agency.

Third, the Fifth Circuit addressed the open issue regarding the removability of the SEC ALJs from Lucia and Cochran. The Fifth Circuit concluded that SEC ALJs perform executive functions yet are unconstitutionally unaccountable to the president.

If the Supreme Court endorses Cochran’s endorsement of pre-enforcement constitutional challenges to SEC administrative proceedings, the procedural calculus for the SEC and respondents would change. Pre-enforcement challenges – constitutional or otherwise – would mire administrative proceedings in even longer delay, duplicative litigation and piecemeal review in multiple appellate courts if the proceeding ends in a final adverse order. And the option of an administrative proceeding may soon not be available in the first place.

If the jury trial analysis in Jarkesy is later adopted by the Supreme Court, the SEC would be foreclosed from commencing administrative proceedings that seek civil monetary penalties and sound in common law fraud. Jarkesy could also be extended to insider trading, which is rooted in the common law tort of breach of fiduciary duty. As a result, the SEC could be litigating more often in federal court, not in SEC courts.

From the respondents’ perspective, pre-enforcement access to federal court eases intense settlement pressure and the disruption and expense of litigating against the SEC in SEC courts for years just to obtain the possibility of review by a federal court. Successful pre-enforcement challenges also would moot the substantial deference that federal courts must give to factual findings made by the SEC in its SEC courts.

Cochran and Jarkesy threaten the viability of the SEC’s home courts. But the reported death of the SEC’s enforcement regime at large has been greatly exaggerated. Before the enactment of the Dodd-Frank Act in 2010, the SEC could bring securities fraud actions against non-registered parties only in federal court. While the SEC increased its use of administrative proceedings post-Dodd-Frank, the SEC has resorted more often to litigating in federal court post-Lucia. And many administrative proceedings have historically been follow-on actions where the SEC seeks additional penalties based on facts already established in a civil or criminal action.

Until the Supreme Court has the last word on the possible constitutional defects in the SEC’s enforcement regime, respondents facing the SEC and other agencies with comparable ALJs should preserve the rights the Fifth Circuit has recognised, both as to the timing of constitutional challenges and the substance of those challenges.

Jonathan C. Bunge is managing partner and Szymon S. Barnas and Rajat Khanna are associates at Quinn Emanuel Urquhart & Sullivan, LLP. Mr Bunge can be contacted on +1 (312) 705 7476 or by email: jonathanbunge@quinnemanuel.com. Mr Barnas can be contacted on +1 (212) 849 7153 or by email: simonbarnas@quinnemanuel.com. Mr Khanna can be contacted on +1 (312) 705 7491 or by email: rajatkhanna@quinnemanuel.com.

© Financier Worldwide

BY

Jonathan C. Bunge, Szymon S. Barnas and Rajat Khanna

Quinn Emanuel Urquhart & Sullivan, LLP

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