The Fifth Circuit’s decision in Jarkesy v. SEC may not be the death blow to the SEC’s enforcement regime it’s been made out to be. But the May ruling could still have subtle but far-reaching consequences, and comes at a time when the SEC faces a barrage of other challenges to its in-house enforcement apparatus.
In Jarkesy, a split Fifth Circuit panel vacated an SEC judgment against hedge fund manager George Jarkesy and investment adviser Patriot 28 LLC, identifying three separate constitutional defects: The petitioners have a right to a jury trial under the Seventh Amendment for actions where the SEC seeks monetary penalties; Congress failed to articulate an “intelligible principle” when it delegated the power to the commission to choose whether it brings cases before its own administrative law judges (ALJs) or in district court; and removal restrictions on ALJs violate Article II of the Constitution, which dictates the president must “take care that the laws be faithfully executed.”
The Jarkesy ruling is one of the most high-profile victories in a broader campaign against the SEC’s use of its in-house proceedings, a campaign that followed the commission gaining expanded authority to seek monetary penalties administratively a dozen years ago under Section 929P(a) of the Dodd-Frank Act.
The commission now faces the question of how to respond to Jarkesy at a time when it’s fending off several other parallel attacks. The Supreme Court in May also granted the petition in SEC v. Cochran that will determine whether a constitutional challenge to an ongoing administrative proceeding can be heard in district court.
At the same time, Republican lawmakers - looking ahead to gains in the midterms elections that could reverse partisan control of Congress – are proposing a package of “JOBS Act 4.0” securities law reforms that includes a measure, the Administrative Enforcement Fairness Act, allowing certain respondents in administrative proceedings to choose between the in-house and district court venues, with some significant caveats.
The commission did notch one victory with the Supreme Court’s June 21, 2022, rejection of the petition in Romeril v. SEC, which had challenged the commission’s use of “no-deny” provisions as part of settlements.
Post-Lucia Shift
The immediate practical consequences of Jarkesy are limited by the fact that litigated administrative proceedings are now rare, with the SEC choosing to bring those cases in district court and instead relying on home-court proceedings for settled actions. Former SEC enforcement officials attribute this shift to the Supreme Court’s 2018 ruling in Lucia v. SEC, in which the court found ALJs are “inferior officers” subject to the Appointments Clause of the Constitution, and therefore must be appointed by the President, judiciary, or agency heads – upending a system in which the ALJs were hired by the chief administrative law judge, and leading the SEC to send back dozens of administrative cases for a rehearing. Those cases included the proceedings against accountant Michelle Cochran, the respondent in SEC v. Cochran.
“The SEC and specifically the Division of Enforcement have typically stayed away from litigated administrative proceedings whenever possible, given the constitutional uncertainty that Lucia presented,” said Scott Mascianica, a partner with Holland & Knight LLP and a former assistant regional director for enforcement at the SEC Fort Worth Regional Office.
The SEC has yet to signal plans on seeking en-banc review by the full Fifth Circuit or appeal to the Supreme Court. Complicating matters is the conservative makeup of the High Court, where the SEC risks cementing nationwide a decision now limited to the Fifth Circuit, which encompasses Louisiana, Mississippi, and Texas.
“It’s a tough strategic decision,” said DLA Piper Partner Deborah Meshulam, former assistant chief litigation counsel for the SEC Division of Enforcement. “There’s plenty of action in Texas. To wipe out an entire series of states, the ability to go administratively, doesn’t seem sensible to me. And this is not a commission that shies away from tough challenges.”
Added Meshulam: “If I were the chair of the SEC, I would be thinking very hard about an en-banc appeal possibly to be followed by certiorari,” she said, referring to the process of petitioning the Supreme Court for review.
An SEC spokesman, in a statement, said “we are reading and assessing the decision to determine appropriate next steps, working alongside the Department of Justice.”
Mascianica said he doesn’t “see how they can’t appeal this decision, just given how far ranging it is not just for the SEC, but for federal agencies in general.”
He sees the ALJ removal restriction component of the Jarkesy opinion – which is also an underlying issue in Cochran – as having the potential to throw not just SEC ALJ proceedings in flux but other agency proceedings as well.
In the Jarkesy majority opinion, Judge Jennifer Walker Elrod wrote that SEC ALJs perform substantial executive functions, and the president therefore “must have sufficient control over the performance of their functions, and, by implication, he must be able to choose who holds the positions.”
The two layers of for-cause removal protection that ALJs now have “impede that control.” ALJs, Elrod noted, can only be removed for cause by the commission as determined by Merit Systems Protection Board (MSPB), and SEC commissioners and MSPB members can only be removed for cause by the president. That double-layer of removal protections, Elrod concluded, is unconstitutional under the 2010 Supreme Court Ruling in Free Enterprise Fund v. PCAOB, which invalidated similar protections and freed the SEC to remove PCAOB members at will.
Notably, while the Fifth Circuit held that the statutory removal restrictions for SEC ALJs were unconstitutional, it relied on the other two defects to vacate the judgment against Jarkesy and did not address whether vacating based on the removal restrictions alone would be appropriate.
Ilan Wurman, an associate professor at Arizona State University’s Sandra Day O’Connor College of Law, said the dual for-cause removal holding “follows very cleanly from the Free Enterprise case, on the theory that everything administrative agencies do is in fact executive power, even if some of what they do take adjudicatory forms.” He predicted the Supreme Court would uphold that aspect of Jarkesy.
On the second Jarkesy holding, the Fifth Circuit concluded that Congress handed the SEC significant legislative power “by failing to provide it with an intelligible principle to guide its use of the delegated power.” Under Dodd-Frank Section 929P(a), Congress gave the SEC “unfettered discretion” to choose between an administrative proceeding and district court, without necessary guidance on how to exercise that open-ended authority.
The first holding, related to the right to a jury trial, hinged on the language of the Seventh Amendment that “in suits at common law, where the value in controversy shall exceed twenty dollars, the right of trial by jury shall be preserved, and no fact tried by a jury, shall be otherwise reexamined in any Court of the United States, than according to the rules of the common law.”
“Under the Seventh Amendment, both as originally understood and as interpreted by the Supreme Court, the jury-trial right applies to the penalties action the SEC brought in this case,” Elrod wrote in the opinion, likening the actions brought by the SEC seeking civil penalties under the securities laws to traditional actions in debt.
“The point is, in a narrow slice of cases where agencies sue you for monetary penalties for violating a statute, why shouldn’t you get a jury?” Wurman said. “You can quibble with the specifics of each of the three holdings, but that’s what it really boils down to. Has the SEC been declared to be unconstitutional? No, of course not, that’s ridiculous. Anyone who says to the contrary isn’t being serious.”
Regardless of the outcome of Jarkesy, the SEC will still have at least some administrative remedies, and “can always go to court,” Meshulam said.
“The SEC has been litigating in federal district court since it’s been litigating, and we should expect that they’ll be able to adapt,” she said.
Cochran and Romeril
Also in May, the Supreme Court granted the petition in SEC v. Cochran, six years after the SEC launched administrative proceedings that resulting in an ALJ banning Cochran from practicing before the SEC for five years and imposing a $22,500 penalty related to her alleged failure to comply with PCAOB auditing standards.
After her case was remanded post-Lucia, she sued the SEC in the Northern District of Texas, also attacking the multiple-layers of for-cause removal protection for commission ALJs. The district court tossed the case over lack of jurisdiction, citing a provision of the Securities Exchange Act of 1934 that barred the court from hearing challenges to administrative proceedings. After Cochran appealed, a Fifth Circuit panel affirmed the district court’s decision. But after an en banc rehearing, the full appeals court concluded the Exchange Act “did not explicitly or implicitly strip the district court of jurisdiction over Cochran’s claim” and remanded the case for further proceedings.
Under the Exchange Act, “a person aggrieved by a final order of the Commission entered pursuant to this chapter may obtain review of the order in the United States Court of Appeals for the circuit in which he resides or has his principal place of business, or for the District of Columbia Circuit.”
The Fifth Circuit concluded that the provision, using the term “may,” is “phrased in permissive terms” that doesn’t cut off other routes of federal court review. The statute “says nothing about people, like Cochran, who have not yet received a final order of the Commission.”
“Nor does it say anything about people, again like Cochran, who have claims that have nothing to do with any final order that the Commission might one day issue. Cochran’s removal power claim challenges the constitution of the tribunal, not the legality or illegality of its final order. Her injury has absolutely nothing whatsoever to do with a final order, and therefore her claim falls outside of” the Exchange Act provision, the Fifth Circuit concluded.
Cochran, Meshulam noted, “doesn’t get to the particular merits of the argument around unconstitutionality of the ALJ removal protections.”
“Cochran to me is much more procedural in the sense of the fundamental question of whether these issues, these constitutional issues…can be heard in district court in the first instance, before the administrative proceeding runs its course,” she said.
The petition Romeril v. SEC stemmed from former Xerox CFO Barry Romeril’s effort to lift a nearly two-decade-old SEC gag order against him. In 2003, Romeril and five other ex-Xerox executives agreed to pay more than $22 million in penalties, interest, and disgorgement to settle fraud charges related to the use of GAAP-violating accounting devices that accelerated the company’s revenue and pre-tax earnings, which was not disclosed to investors.
Romeril, while neither admitting nor denying the findings, agreed in a consent agreement not to make public statements denying the SEC allegations – referred to as a “no-deny” provision – but in 2019 asked the U.S. District Court for the Southern District of New York to void that judgment, indicating he wanted to “speak, write, or publish” about his case. The district court rejected the motion as untimely and failing to “allege a jurisdictional defect or violation of due process that would permit relief” under the Federal Rules of Civil Procedure. And in September 2021, a three-judge panel of the Second Circuit affirmed that lower court decision.
Under the so-called “Gag Rule” of 1972, the SEC has adopted a policy that in civil lawsuits or administrative proceedings “it is important to avoid creating, or permitting to be created, an impression that a decree is being entered or a sanction imposed, when the conduct alleged did not, in fact, occur.”
“Accordingly, it hereby announces its policy not to permit a defendant or respondent to consent to a judgment or order that imposes a sanction while denying the allegations in the complaint or order for proceedings,” the regulation states. “In this regard, the Commission believes that a refusal to admit the allegations is equivalent to a denial, unless the defendant or respondent states that he neither admits nor denies the allegations.”
Romeril argued that the Gag Rule violates due process of law by requiring settling defendants to waive their constitutional rights, including the “right to freely exchange their views of their administrative process at the end of a government proceeding.”
The Supreme Court’s denial of the petition removes a potential hazard to a major SEC enforcement mechanism. Mascianica - interviewed before the petition was rejected – said he saw ramifications of Romeril for SEC gag orders as among the biggest potential impacts of the three cases.
“If no-admit, no-deny is no longer an option, the impact for the SEC’s Division of Enforcement arguably blows out of the water any impact from an inability to litigate in administrative proceedings,” he said. “No-admit, no-deny is how the agency has generally settled matters for the last 50 years.”
Congress’ Role
An open question is whether Congress will act to clarify the SEC’s administrative authority amid the judicial uncertainty, as it did to cement the commission’s power to collect disgorgement in light of the Supreme Court’s 2017 decision in Kokesh v. SEC.
For Jarkesy, Meshulam sees a possibility for Congress to act to address the “intelligible principle” issue in the second holding. Not so for the other two holdings, however.
“I don’t think it can necessarily resolve the issue about deprivation of rights to a jury trial so long as the authority for the SEC to collect civil penalties administratively remains,” she said. Nor does she believe lawmakers can easily solve the ALJ removal protection issue.
“It can’t be just SEC focused,” she said. “That issue has potential impact across a wide array of administrative agencies. So I think there could be some but not complete legislative fixes on these issues.”
Republicans in Congress, however, have proven far more hostile to the SEC’s use of its in-house proceedings than Democrats, and would be less likely to agree to any Jarkesy fix should they regain one or both chambers of Congress following the midterm elections.
To underscore the GOP’s hostility towards the SEC’s use of ALJs, in April, the Senate Banking Committee released its JOBS Act 4.0 package containing the Administrative Enforcement Fairness Act, sponsored by Sen. Cynthia Lummis, a Wyoming Republican. The measure would stipulate that: “any administrative proceeding brought by the Commission under this Act may be removed by the eligible respondent to the district court of the United States.”
The bill’s benefits are limited, however, by a long list of exclusions. An “eligible respondent” does not include a registered broker or dealer, registered investment adviser, registered investment company, registered municipal securities dealer, registered nationally recognized statistical rating organization, registered government securities broker, registered government securities dealer, registered public accounting firm, or a registered transfer agent, according to the bill text.
This article was updated on June 21 to reflect the Supreme Court’s denial of the petition in Romeril v. SEC.
This article originally appeared in the June 17, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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