On May 18, the Fifth Circuit issued an opinion vacating a Securities and Exchange Commission administrative law judge’s decision that George Jarkesy Jr. and his investment adviser Patriot28 committed securities fraud. The court, in an opinion authored by Judge Jennifer 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.
While each of these holdings is noteworthy, it is the second holding and its use of the nondelegation doctrine to invalidate congressional delegation for the first time since 1935 that could drastically affect the use of in-house administrative judges, and perhaps even rulemaking, at the SEC and other agencies.
Facts, a Remand and a Related Supreme Court Cert
George Jarkesy Jr. created two hedge funds and selected Patriot28 (Jarkesy and Patriot28 were the petitioners in the appeal) 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 the 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.” The petitioners were eventually found liable by an SEC ALJ, and that finding was affirmed by the agency. The SEC ordered that the petitioners cease and desist from committing further violations, pay a civil penalty of $300,000 and disgorge around $685,000. Additionally, Jarkesy was barred from various industry activities.
During these administrative proceedings, the petitioners raised several constitutional arguments, which the SEC rejected. The petitioners then filed a petition for review in the Fifth Circuit Court of Appeals. The Fifth Circuit agreed with several of the petitioner’s constitutional arguments and granted the petition for review, vacated the SEC’s decision and remanded for further proceedings. Given the court’s opinion, the SEC’s likely next step would be to bring the charges against the petitioners in an Article III court.
This ruling comes just days after the U.S. Supreme Court granted certiorari in another Fifth Circuit decision against the SEC’s in-house administrative tribunals in a more narrow case, Cochran v. SEC. In Cochran, the Fifth Circuit held that the district court had jurisdiction to hear Cochran’s claim that the removal processes in place for SEC ALJs were unconstitutional before the SEC entered a final judgment against her. Both of these cases could chip away at the ability of SEC ALJs to adjudicate enforcement actions in the future.
The Three Jarkesy Holdings
The Fifth Circuit’s May 18 opinion contained three important holdings for future SEC matters. First, the court held that the use of an SEC ALJ to adjudicate the claims deprived the 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, the Supreme Court has held that 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, though statutory, had their roots in 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 industry 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 the argument made by the SEC and in the dissenting opinion 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.
Second, the court went on to vacate the SEC’s decision on alternative grounds that could have wide-ranging implications for the “administrative state.” 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.
Third and 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 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.
Reviving the Nondelegation Doctrine: How Far Will It Go?
The legal and practical consequences of Jarkesy will depend on how broadly the court’s holdings are applied. For instance, the court’s Seventh Amendment holding may be fairly moot, in a practical sense, given that the SEC has shifted away in recent years from bringing claims like the ones the petitioners faced before ALJs. However, the court’s use of the long-dormant nondelegation doctrine to curtail the SEC’s authority could be foreshadowing a shift in opinions against administrative proceedings more generally. The court could have easily vacated the SEC’s decision and remanded the petitioners’ case on the Seventh Amendment grounds only. Instead, the Fifth Circuit made clear that congress’ unconstitutional delegation was “an alternative holding” for vacating the judgment and should be considered “binding precedent,” making it the first time this principle has been evoked to invalidate a congressional delegation in 87 years.
If congressional delegation is now suspect, this issue could extend far beyond SEC administrative proceedings. Many agencies, including the SEC, have also been delegated immense rulemaking authority. While the court did not directly attack agencies’ ability to legislate, the opinion’s broad sweeping language about separation of powers and accountability suggests that agency rulemaking authority could be ripe for challenge. For instance, the SEC’s recent wave of aggressive rulemaking could face serious scrutiny under the nondelegation doctrine’s “intelligible principle” test, given that the SEC’s authority is solely based on congress’ mandate to “protect investors.” Additionally, agencies across the country adjudicate hundreds of cases any given day under the power delegated to them by congress. Invalidating these proceedings could flood the already backlogged Article III courts with thousands of new proceedings. Cases involving securities fraud, Medicare, disability benefits, immigration and more could sit on dockets for years waiting to be adjudicated.
While the short-term effects of this decision may be minor, especially given the SEC’s shift away from disputed administrative proceedings, the Jarkesy opinion indicates a first step towards potentially big changes for agency adjudication. The court’s citation to Justice Neil Gorsuch’s dissent in Gundy v. United States seems to signal to the conservative majority on the Supreme Court that Jarkesy presents a prime opportunity to begin shifting power back to the legislative branch.
Rebecca Fike and John Wander are partners and Avery Westerlund is an associate in Vinson & Elkins’ Shareholder Litigation & Enforcement practice. Wander also currently serves as the firm’s general counsel.