On June 27, 2024, the United States Supreme Court in Securities and Exchange Commission v. Jarkesy determined that when the Securities and Exchange Commission (SEC) brings a securities fraud claim against a defendant seeking civil penalties, it must do so in federal court rather than using its in-house administrative law judge (ALJ) system. The decision was based on the defendants' right to a jury trial under the Seventh Amendment.
The Securities Exchange Act of 1934 (Exchange Act) and other federal securities laws allow the SEC to bring enforcement proceedings before its ALJs with the SEC acting as both prosecutor and judge. The ALJ issues an initial decision, which the losing party, either the respondent or the Division of Enforcement, can appeal to the full Commission. If the ALJ's initial decision is not appealed, it becomes final. After an appeal to the full Commission, a party can seek review by a Circuit Court of Appeals.
The Jarkesy decision, however, now requires that when the SEC seeks civil penalties, those claims must be brought before Article III courts, and the right to trial by jury attaches. According to a report published in 2017, the SEC won approximately 90% of its contested matters before its in-house judges, compared with about 69% of those cases litigated in District Court.1 This is, in part, because several procedural protections courts provide litigants are simply absent in the SEC's internal proceedings.
- In court, a defendant can obtain discovery from the SEC as in
any civil case. Before an ALJ, a respondent does not have a general
broad right to discovery. The SEC must merely provide
"material exculpatory evidence."2
- In court, a defendant can take ten discovery depositions (or more with leave of court) and subpoena third parties for trial testimony. Before an ALJ, oral depositions are limited to five (although the ALJ can permit two more), and ALJs have the discretion not to issue or to significantly limit the scope of subpoenas requested by respondents.
- In a civil matter, the court can set flexible discovery deadlines to accommodate complex cases, while SEC rules require that hearings take place comparatively quickly after proceedings are instituted.
- The Federal Rules of Evidence apply in court to protect the defendant, while the rules are far more limited in agency proceedings. ALJs often permit and consider the investigative testimony taken by the enforcement division, which is sworn testimony that is taken outside the presence of the respondent, and not subject to cross-examination.
- Where a respondent seeks a procedural challenge to the enforcement action before an ALJ, often including to the ALJ's authority, that challenge can frequently be heard only by the ALJ in the first instance, and then the Commission.
- Critically, as was the Court's focus here, defendants in federal court can have their cases heard by a jury of their peers.
The differences between agency hearings and federal court litigation provide the SEC with an enormous advantage. The decision in Jarkesy will give individuals and businesses subject to SEC enforcement a greater opportunity to make their case to avoid civil penalties in the future.
Background
George Jarkesy, Jr. launched two investments funds, raising around $24 million from investors. Patriot28, managed by Jarkesy, served as the funds' investment adviser during that time period. The SEC initiated an enforcement action against Jarkesy and Patriot28, contending that they violated the antifraud provisions of the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Advisers Act of 1940. The SEC claimed the defendants misled investors by (1) misrepresenting their investment strategies, (2) lying about the identity of the funds' auditor and prime broker, and (3) inflating the funds' value. As part of the enforcement action, the SEC sought civil penalties and other remedies.
The SEC could have sued Jarkesy and Patriot28 in federal court. But the 2010 Dodd-Frank Act also gave the SEC the ability to bring enforcement actions seeking monetary penalties before its own ALJs. The SEC took that route, and the ALJ levied a civil penalty of $300,000 against Jarkesy and Patriot28. On review, a Fifth Circuit panel vacated the ALJ's order, finding that the proceeding violated the Seventh Amendment. The Supreme Court granted certiorari.
The Decision
In analyzing the case, the Supreme Court followed the approach set forth in Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989)and Tull v. United States, 481 U.S. 412 (1987). The Court observed that the Seventh Amendment guarantees that in "[s]uits at common law . . . the right of trial by jury shall be preserved." In construing that guarantee, the Supreme Court held that courts must determine if a cause of action is legal or equitable. If a claim resembles a common law cause of action and is the sort that is traditionally obtained in a court of law, then the claim is a legal rather than equitable one and the Seventh Amendment guarantee must be enforced.
The remedy at issue here was legal. Civil penalties seek to punish and deter wrongdoing. The other tools on the SEC's tool belt — restitution and cease and desist orders — are equitable in that they seek to maintain the status quo. Here, however, since the penalties were designed to punish and deter, rather than to compensate, they were a type of remedy that could only be enforced in courts of law.
According to the Court, when the SEC seeks civil penalties designed to punish or deter wrongdoing, a jury trial must be available to a defendant.
Impact of the Ruling
The SEC enjoys an immense advantage when litigating before its in-house judges. While the SEC has very often brought securities fraud actions in federal court in the past to avoid challenges to its administrative process (like Jarkesy's successful challenge), this ruling could further erode the use of ALJs by the SEC. This would level the playing field between the SEC and its opponents and undercut the SEC's distinct advantage in agency proceedings.
Targets of other agency actions should take note of the Jarkesy decision. As Justice Sotomayor writes in her Jarkesy dissent, there are, at the very least, more than two dozen agencies that can impose civil penalties in administrative proceedings. Defendants facing potential civil penalties in actions brought by the Commodity Futures Trading Commission, the Consumer Financial Protection Bureau, or the Environmental Protection Agency, for example, may want to consider Seventh Amendment challenges to those proceedings.
Footnotes
1. D. Thornley & J. Blount, SEC In-House Tribunals: A Call for Reform, 62 Vill. L. Rev. 261, 286 (2017).
2. 17 CFR §201.230(b)(3).
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