On May 18, 2022, the Fifth Circuit issued an opinion vacating a Securities and Exchange Commission (“SEC”) Administrative Law Judge’s (“ALJ”) decision that George Jarkesy, Jr. (“Jarkesy”) and his investment adviser Patriot28, L.L.C. (“Patriot28”) committed securities fraud. The Court, in an opinion authored by Judge Jennifer Walker Elrod, held that “(1) the SEC’s in-house adjudication of Petitioners’ case violated their Seventh Amendment right to a jury trial; (2) Congress unconstitutionally delegated legislative power to the SEC by failing to provide an intelligible principle by which the SEC would exercise the delegated power, in violation of Article I’s vesting of “all” legislative power in Congress; and (3) statutory removal restrictions on SEC ALJs violate the Take Care Clause of Article II.” This decision could drastically affect the SEC’s use of in-house administrative judges to bring enforcement actions.

Jarkesy created two hedge funds and selected Patriot28 (together “Petitioners”) as the investment adviser. The funds recruited over 100 investors and managed over $20 million in assets. In 2011, the SEC launched an investigation into the funds and eventually brought an administrative action against the Petitioners. The SEC alleged that Petitioners: “(1) misrepresented who served as the prime broker and as the auditor; (2) misrepresented the funds’ investment parameters and safeguards; and (3) overvalued the funds’ assets to increase the fees that they could charge investors.” Petitioners were eventually found liable by an SEC administrative law judge and that finding was affirmed by the Commission. The Commission ordered that Petitioners cease and desist from committing further violations, pay a penalty of $300,000, and disgorge around $685,000. Additionally, Jarkesy was barred from various industry activities. During these administrative proceedings, Petitioners raised several constitutional arguments, which the Commission rejected. Petitioners then filed a petition for review in the Fifth Circuit Court of Appeals. The Fifth Circuit today agreed with several of Petitioner’s constitutional arguments and granted the petition for review, vacated the SEC’s decision, and remanded for further proceedings.

The May 18th opinion contained several important holdings for future SEC matters. First, the Court held that the use of an SEC ALJ to adjudicate the claims deprived Petitioners of their Seventh Amendment right to a jury trial. Congress has the power to assign certain proceedings involving public rights to administrative adjudication, eliminating the right to a jury. However, Congress may not assign proceedings that involve common law claims seeking civil penalties to administrative agencies. Here, the Court held that the claims brought by the SEC arose from common law fraud claims and thus the right to a jury could not be removed. Despite the mix of legal claims, including the monetary penalties, and equitable claims, such as barring Jarkesy from industries activities, the Court determined that the “penalty facet of the action suffice[d] for the jury-trial right to apply[.]”

The majority was not convinced by either the SEC, or the dissent’s, argument that the presence of the government transformed this action into a public rights claim suitable for administrative adjudication. The Court reasoned that “Congress cannot change the nature of a right, thereby circumventing the Seventh Amendment, by simply giving the keys to the SEC to do the vindicating.” Given that federal courts have dealt with securities claims, and fraud claims more broadly, for decades and such claims were “quintessentially about the redress of private harms[,]” the Court saw no reason to find that the SEC’s presence negated the right to a jury.

Next, the Court held that Congress unconstitutionally delegated legislative power to the SEC when it gave the SEC full discretion to choose whether to bring actions in an Article III court or before an ALJ. The power to determine which cases are decided by an administrative tribunal and which are decided by an Article III court is legislative in nature. When Congress delegates such legislative power, it must offer an intelligible principle by which to exercise such power. Here, the Court held that Congress had “offered no guidance whatsoever.” Thus, the delegation was unconstitutional.

Finally, the Court held that statutory restrictions on the removal of the SEC’s ALJs were unconstitutional. Per the opinion, the president must have sufficient control over individuals who serve important executive functions and the Supreme Court has previously held that two layer for-cause protection for inferior offices is unconstitutional. Currently, SEC ALJs can only be removed for good cause by the Merits System Protection Board (“MSPB”). MSPB members can only be removed for cause by the president. Thus, the Court held that SEC ALJs were protected by a two layer for-cause removal standard and such statutory removal restrictions were unconstitutional.

The Court vacated and remanded Petitioners’ case for further proceedings. Given the Court’s opinion, the SEC’s likely next step would be to bring the charges against Petitioners in an Article III court.

This ruling comes just days after the U.S. Supreme Court granted certiorari in a 5th Circuit decision against the SEC in another, more narrow case, Cochran v. SEC, 20 F.4th 194 (5th Cir. 2021), challenging the agency’s in-house administrative tribunals. Both of these cases could greatly limit the ability of SEC ALJs to adjudicate enforcement actions in the future.