In the Shadow of Lucia: The Uncertain Future of SEC Administrative Proceedings

The US Securities and Exchange Commission (SEC or Commission) is an independent agency that investigates potential violations of the federal securities laws. At times, it also acts as both prosecutor and adjudicator when it enforces such laws in administrative proceedings. In recent years, respondents have successfully challenged the constitutionality of certain aspects of SEC administrative proceedings—and, in recent weeks, noteworthy developments in two cases could significantly affect whether the Commission will be able to continue instituting and litigating enforcement actions in such proceedings. This Advisory covers the background of SEC administrative proceedings, discusses the recent case developments, and identifies key takeaways and open questions that will need to be answered before the fate of SEC administrative proceedings can be decided.

Background of SEC Administrative Proceedings

The debate over the appropriate functions of independent agencies, including the SEC, is nothing new. It dates to the 1930s, when many of these agencies were created, and has focused on the varying powers delegated by Congress. As discussed in a Report on Regulatory Agencies issued in 1960 by James Landis, who had served as the second Chair of the SEC, one of the reasons for this delegation was a belief that “the problems in a particular area were so manifold and complex that the Congress simply had neither the time nor the capacity to handle them” through the legislative process. Moreover, according to Landis, the delegation of adjudicatory powers to the regulatory agencies “stemmed from the conviction that the issues involved were different from those that theretofore had been traditionally handled by courts and thus were not suited for judicial determination.” As a result, given that regulatory agencies possessed highly specialized subject matter expertise, Congress viewed them as being best positioned to engage in rulemaking, promulgate policy, investigate and prosecute violations, and adjudicate enforcement matters relating to the industries they regulated.

Over the years, these wide-ranging powers caused what Landis called “problems common to all the regulatory agencies.” As Landis described, one of the earliest problems was “the combination of prosecuting and adjudicatory functions within the same agency,” which “eventually led to the passage of the Administrative Procedure Act of 1946 with its emphasis upon the internal separation of these functions within the agency and the granting of some degree of independence to the hearing examiners.” As for the SEC, this also meant that Congress initially limited the agency’s adjudicatory powers as well as the enforcement remedies available to it. In this regard, in its early years, the SEC could seek injunctive relief in the federal district courts or it could institute administrative proceedings—but such proceedings could only be brought against regulated entities (such as broker-dealers) in an effort to seek remedial sanctions (such as trading suspensions).

As time passed, however, Congress granted the Commission more and more authority (and available remedies) in administrative proceedings, often in response to securities scandals and adverse market events. For example:

• Expansion of authority after the Treadway Commission’s Report on Fraudulent Financial Reporting and stock market crash of 1987. The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 authorized the Commission to use administrative proceedings to (i) issue cease-and-desist orders against anyone who is found to have violated the federal securities laws and (ii) impose civil money penalties against regulated entities and their associated persons.
• Expansion of authority after the Enron and WorldCom scandals and tech wreck of 2000. The Sarbanes-Oxley Act of 2002 authorized the Commission to use administrative proceedings to bar individuals from serving as officers or directors of public companies if such individuals are found to have violated the scienter-based antifraud provisions of the federal securities laws.
• Expansion of authority after the Madoff scandal and financial crisis of 2008. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) authorized the Commission to use administrative proceedings to impose civil money penalties against anyone who is found to have violated the federal securities laws, meaning that the SEC’s ability to assess penalties in administrative proceedings is no longer limited to regulated entities and their associated persons.

As a result of these changes, Congress has all but obliterated the important distinctions that historically existed between the SEC’s federal district court actions and administrative proceedings. The Commission now has essentially the same menu of enforcement tools if it brings an administrative proceeding before one of its own Article I ALJs as it would if it were to bring the case as a federal district court action before an Article III judge. There remain some minor differences—for example, the Commission issues cease-and-desist orders in administrative proceedings while it seeks injunctions in federal court actions—but, under the current legislative framework, civil money penalties, disgorgement, pre-judgment interest, officer and director bars, and other equitable relief are all available to the Commission, regardless of the forum selected.

The SEC’s Use of Its Expanded Authority and the Resulting Backlash

As the SEC was granted broader authority in administrative proceedings, it took advantage of its new powers. The first major signal that the Commission might shift to using administrative proceedings more frequently (and forcefully) was its insider trading action against Rajat Gupta. Despite the fact that the SEC historically had sued alleged insider traders in federal district court, in March 2011, the Commission issued an order instituting administrative proceedings against Gupta, which alleged that he had violated the antifraud provisions of the federal securities laws by engaging in insider trading. This was a wake-up call to the securities bar and others in the industry, as it was a clear departure from the Commission’s prior practice. In response to the action, Gupta sued the SEC in federal district court, alleging that the agency deprived him of equal protection under the law given that it had sued a number of other individuals involved in the alleged insider trading scheme in court rather than instituting administrative proceedings against them. In response to Gupta’s lawsuit, the Commission, on its own accord, dismissed the administrative proceeding against him in August 2011—but then, less than three months later, the SEC filed a complaint against Gupta in federal district court and litigated that case to a judgment.

Although the Commission reversed course in the Gupta action, it was not deterred from bringing an increasing number of enforcement actions as administrative proceedings, and the SEC staff was open about its intention to do so. For example, in 2013, an article in the New York Times quoted Andrew Ceresney (then the Co-Director of the SEC’s Division of Enforcement) as stating, “Our expectation is that we will be bringing more administrative proceedings given the recent statutory changes.” And the agency did just that. The number of SEC administrative proceedings rose significantly beginning in 2012, and, at the same time, there was a corresponding drop in enforcement actions brought in federal court.¹ Then, in 2014, an article in the Wall Street Journal quoted a senior SEC enforcement official as calling the more frequent use of administrative proceedings “the new normal” for the agency. That same year, the SEC doubled down on its shift to bringing more actions administratively when it added two new ALJs and three new attorneys to its Office of Administrative Law Judges and announced that these “additions will nearly double the size of the office.”

This dramatic shift was not without controversy. Critics primarily argued that the Commission had a home court advantage when litigating before its own ALJs. There also was public outcry about the inherent unfairness of the fact that (i) respondents are required to appeal any adverse decision by an ALJ to the Commission itself before having an opportunity to be heard by a federal appellate court, and (ii) once a Commission opinion is appealed, the appellate court must apply deference by assuming the administrative decision approved by the Commission was correct unless unreasonable. One vocal critic of the SEC’s shift was Judge Jed S. Rakoff of the US District Court for the Southern District of New York, who gave a keynote address at the November 2014 PLI Securities Regulation Institute. In his address, Judge Rakoff provided a short history of SEC administrative proceedings and stated:

In short, what you have here are broad antifraud provisions, critical to the transparency of the securities markets, that have historically been construed and elaborated by the federal courts but that, under Dodd-Frank, could increasingly be construed and interpreted by the SEC’s administrative law judges if the SEC chose to bring its more significant cases in that forum. Whatever one might say about the SEC’s quasi-judicial functions, this is unlikely, I submit, to lead to as balanced, careful, and impartial interpretations as would result from having those cases brought in federal court.

Significantly, the criticism of the SEC’s new emphasis on litigating enforcement actions in administrative proceedings was not limited to public commentary. Respondents in such proceedings took on the fight and began to argue that various aspects of the SEC’s administrative proceeding framework were unconstitutional. One of these cases, Lucia v. SEC, 138 S. Ct. 2044 (2018), made it to the US Supreme Court, which held that the SEC’s in-house ALJs had not been properly appointed. As discussed below, this decision caused a temporary blip in the SEC’s efforts to bring enforcement cases as administrative proceedings, as it compelled the Commission to reconduct administrative hearings before properly-appointed ALJs.

The Lucia decision, however, left open other questions regarding the constitutionality of SEC administrative proceedings. As a result, in the four years since Lucia, the Commission has faced additional challenges, including two recent case developments that could have a significant impact on the agency’s ability to litigate administratively: On May 16, 2022, the Supreme Court granted certiorari in SEC v. Cochran to decide whether a respondent in an ongoing SEC administrative proceeding may immediately seek to enjoin that proceeding or must wait until after a final adverse opinion by the Commission to challenge the process on appeal to a federal appellate court. Two days later, on May 18, 2022, the Fifth Circuit issued an opinion in Jarkesy v. SEC that vacated the Commission’s administrative decision against the petitioners in that case. The Jarkesy opinion included three significant holdings, each of which resulted in a finding that the SEC’s administrative proceeding was unconstitutional. Taken together, Lucia, Cochran, and Jarkesy could reshape how SEC enforcement cases are instituted and litigated.

Lucia and Its Effect on SEC Administrative Proceedings

In June 2018, a 7-2 majority of the Supreme Court held that SEC’s ALJ are “officers” within the meaning of the Appointments Clause of the US Constitution and that the ALJ who presided over the administrative enforcement proceeding at issue was not properly appointed pursuant to that clause. As discussed in a prior Advisory, the Commission historically took the position that its ALJs were employees (rather than officers) and did not need to be appointed pursuant to the Appointments Clause—and, in the past, there was no serious debate about the constitutionality of the SEC’s ALJs or their authority. The Lucia case, however, involved respondents who challenged the SEC’s position, and this challenge arose at the same time the agency was increasing its use of administrative proceedings post-Dodd-Frank.

The case began in September 2012, when the SEC issued an order instituting administrative cease-and-desist proceedings against Raymond J. Lucia and his investment company, Raymond J. Lucia Companies, Inc. The order was based on allegations that the respondents had violated the antifraud provisions of the Investment Advisers Act of 1940 by making misrepresentations to prospective investors regarding a particular wealth management strategy. In July 2013, an SEC ALJ issued an initial decision finding the respondents liable and imposing civil money penalties and a lifetime securities industry bar on Lucia.²

Upon appeal to the Commission, the respondents argued that the administrative hearing was unconstitutional because the ALJ had not been properly appointed. Under the Appointments Clause, certain senior officials within the government who exercise significant authority pursuant to federal law must be appointed in specific ways. “Principal officers” must be appointed by the President and confirmed by the Senate, while “inferior officers” must be appointed either by the President, the courts of law, or the heads of departments (which, in the case of the SEC, would be the Commission itself). The ALJ presiding over the Lucia case, however, had been hired by the SEC staff and never appointed by the Commission. This notwithstanding, in September 2015, the Commission issued an opinion affirming the ALJ’s decision and concluding that the agency’s ALJs were not “officers” under the Appointments Clause.

The respondents then took their challenge to federal court, but the DC Circuit rejected the argument that the appointment of SEC ALJs was unconstitutional. Lucia v. SEC, 832 F.3d 277, 284-89 (D.C. Cir. 2016). The Supreme Court thereafter granted certiorari and, in June 2018, issued a decision reversing the DC Circuit and holding that SEC ALJs are, in fact, “officers” within the meaning of the Appointments Clause.

In the majority opinion authored by Justice Kagan, the Supreme Court concluded that SEC ALJs exercise significant authority under federal law, including because they have “nearly all the tools of federal trial judges.” In particular, according to the Court, SEC ALJs (i) take testimony by receiving evidence, examining witnesses at hearings, and taking pre-hearing depositions, (ii) conduct trials by administering oaths, ruling on motions, and generally regulating the course of hearings as well as the conduct of parties and counsel, (iii) rule on the admissibility of evidence, thereby critically shaping the administrative record, and (iv) have the power to enforce compliance with discovery orders. The Court also noted that SEC ALJs issue decisions at the close of proceedings that potentially have an independent effect due to the fact that the Commission may decide not to review an ALJ decision; when this happens, the ALJ decision “becomes final” and is “deemed the action of the Commission.” According to the Court, this “last-word capacity” meant that SEC ALJs are officers under the Appointments Clause.

Interestingly, before the Supreme Court issued its opinion in Lucia, the Solicitor General submitted a brief taking the position—contrary to the government’s prior position in the litigation—that SEC ALJs are officers for purposes of the Appointments Clause but recommending that the Court appoint an amicus curiae to defend the contrary judgment of the DC Circuit.³ And, before the case was decided, the Commission issued an order that ratified the prior appointment of its ALJs in an effort to “put to rest any claim that administrative proceedings pending before, or presided over by, [ALJs] violate the Appointments Clause.” The order also directed ALJs presiding over then-pending proceedings to take certain actions that involved reconsidering the record and deciding whether to ratify or revise all prior actions taken by the ALJs. In other words, the Commission was preparing for what ended up becoming the Lucia decision.

Once the Supreme Court rendered its decision, the Commission stayed all of its administrative proceedings, presumably to give the agency time to further determine the implications of the decision. Then, in August 2018, the Commission issued an order lifting the stay and providing all respondents in pending administrative proceedings with the opportunity for a new hearing before an ALJ who did not previously participate in the matter. The SEC thus had its fix to the Appointments Clause issue and, over the past four years, resumed its efforts to initiate and litigate enforcement actions in administrative proceedings. The constitutional challenges to such proceedings, however, were not done.

The Question Before the Supreme Court in Cochran

In Cochran, the SEC issued an order instituting administrative proceedings in 2016 against Michelle Cochran, a licensed CPA, for alleged violations of auditing standards in connection with the audits of public companies. After a hearing, the SEC ALJ issued an initial decision finding Cochran liable, issuing a cease-and-desist order against her, requiring that she pay a civil money penalty, and denying her the privilege of appearing or practicing before the Commission under Section 4C of the Securities Exchange Act of 1934 (Exchange Act) and Rule 102(e) of the Commission’s Rules of Practice, with the right to reapply after five years.

While Cochran’s petition asking the Commission to review the ALJ’s decision was pending, the Supreme Court handed down its decision in Lucia. As a result, the Commission remanded Cochran’s matter to be re-heard by a different ALJ who had been properly appointed. Rather than re-litigating the matter before a new ALJ, however, Cochran filed suit in the US District Court for the Northern District of Texas, seeking to enjoin the SEC’s administrative proceeding. Cochran’s argument in federal court was that the ALJ was unconstitutionally insulated from the President’s removal power.

The district court dismissed Cochran’s lawsuit, finding that it did not have subject-matter jurisdiction because Congress had implicitly divested district courts of jurisdiction over hearing challenges to SEC administrative proceedings. Cochran v. SEC, No. 4:19-CV-066-A (N.D. Tex. Mar. 25, 2019). In particular, Section 25 of the Exchange Act authorizes “a person aggrieved by a final order of the Commission” to “obtain review of the order” in the applicable federal court of appeals. 15 U.S.C. § 78y(a)(1). Section 25 also provides that the courts may not consider any “objection to an order or rule of the Commission” unless the objection “was urged before the Commission or there was reasonable ground for failure to do so.” 15 U.S.C. § 78y(c)(1). The district court in Cochran pointed to cases in the Second, Fourth, Seventh, Eleventh, and DC Circuits, each of which had “concluded that district courts lack jurisdiction over challenges to SEC proceedings, including pre-enforcement attacks on their constitutionality, because Congress intended to divest them of that jurisdiction” by passing Section 25 of the Exchange Act.

After Cochran appealed, a Fifth Circuit panel initially affirmed the dismissal. The Fifth Circuit then granted rehearing en banc to determine the jurisdictional question. And, on December 13, 2021, the Fifth Circuit reversed, finding that the Exchange Act did not explicitly or implicitly divest federal district courts of jurisdiction to hear constitutional claims before the Commission makes a final decision following a hearing before an in-house ALJ. Cochran v. SEC, 20 F.4th 194 (5th Cir. 2021).

In its opinion, the Fifth Circuit first addressed the statutory text of Section 25 of the Exchange Act, noting that it applies to persons aggrieved by a final order of the Commission but that it “says nothing about people, like Cochran, who have not yet received a final order of the Commission” and “who have claims that have nothing to do with any final order that the Commission might one day issue.” The court also noted that the statute is “phrased in permissive terms” in that an aggrieved person “may” seek review in the applicable court of appeals. As a result, the court concluded that this should not eliminate “alternative routes to federal court review,” particularly when the statute “elsewhere uses mandatory terms.”

The Fifth Circuit also relied heavily on Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), stating that the Supreme Court’s decision in that case “is enough to decide this case.” The Free Enterprise Fund case involved an accounting firm that, after receiving a critical inspection report from the Public Company Accounting Oversight Board (PCAOB), filed a lawsuit in federal district court seeking a declaratory judgment that the structure of the PCAOB was unconstitutional. The Supreme Court rejected an argument that Section 25 of the Exchange Act deprived the district court of jurisdiction to hear the accounting firm’s constitutional challenges. Instead, the Supreme Court found that the statute “does not expressly limit the jurisdiction that other statutes confer on district courts . . . . Nor does it do so implicitly.” The Fifth Circuit found that “Free Enterprise Fund is squarely on point, foreclosing any possibility that [Section 25] strips district courts of jurisdiction over structural constitutional challenges.”

The Fifth Circuit then addressed other precedents, including Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994), and applied what it called the Thunder Basin factors to determine if Congress intended implicitly to limit the jurisdiction of district courts when it created a statutory framework that delegated initial review to the SEC. Under the Thunder Basin factors, a statute does not implicitly limit a lower court’s jurisdiction (i) if a finding of preclusion could foreclose all meaningful judicial review, (ii) if the suit is wholly collateral to a statute’s review provisions, and (iii) if the claims are outside the agency’s expertise—and the Fifth Circuit concluded that all three factors weighed in Cochran’s favor. Accordingly, the court reversed the dismissal of Cochran’s claim that SEC ALJs are unconstitutionally insulated from the President’s removal power and remanded the case for further proceedings consistent with its opinion.

On May 16, 2022, the Supreme Court granted certiorari to decide “whether a federal district court has jurisdiction to hear a suit in which the respondent in an ongoing [SEC] administrative proceeding seeks to enjoin that proceeding, based on an alleged constitutional defect in the statutory provisions that govern the removal of the [ALJ] who will conduct the proceeding.” While the case is focused on the jurisdictional question, not the underlying constitutional challenge, it could wreak havoc on the SEC’s efforts to litigate cases administratively if the Supreme Court were to issue an opinion that enables all respondents in SEC administrative proceedings to run into federal district court and seek to enjoin such proceedings.

The Fifth Circuit’s Decision in Jarkesy

Just two days after the Supreme Court agreed to hear the Cochran case, the Fifth Circuit issued another opinion regarding the SEC’s authority to initiate administrative proceedings. The Fifth Circuit’s opinion in Jarkesy v. SEC, No. 20-61007 (5th Cir. May 18, 2022), appears to be the strongest position taken to date by a federal court in terms of finding that the Constitution imposes significant constraints on the powers of the SEC.

The procedural history of Jarkesy reveals a contested action that has been litigated for more than nine years:

• The case began as an administrative proceeding in March 2013, when the Commission issued an order instituting proceedings against George Jarkesy and his investment advisory firm. The order alleged that Jarkesy committed securities fraud in connection with the establishment of two hedge funds by, among other things, misrepresenting the funds’ investment parameters and safeguards and overvaluing the funds’ assets.
• In response, Jarkesy sued the SEC in the US District Court for the District of Columbia to enjoin the administrative proceeding, arguing that it violated various constitutional rights. The district court denied his request for an injunction, and the DC Circuit affirmed, deciding that the federal courts do not have jurisdiction to hear a constitutional challenge prior to any adverse order by the Commission. See Jarkesy v. SEC, 48 F. Supp. 3d 32, 40 (D.D.C. 2014), aff’d, 803 F.3d 9, 12 (D.C. Cir. 2015).
• In October 2014, after a hearing, the SEC ALJ issued an initial decision finding that Jarkesy violated the antifraud provisions of the federal securities laws, including Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The ALJ (i) ordered Jarkesy to cease and desist from further violations, (ii) required him to pay disgorgement, prejudgment interest, and a civil money penalty, and (iii) barred him from the securities industry and from acting as an officer or director of a public company.
• Jarkesy then appealed to the Commission. While his petition for review was pending, the Supreme Court issued its decision in Lucia. As a result, the Commission remanded the matter to be heard by a different ALJ who had been properly appointed. Jarkesy, however, waived the right to a new hearing and continued under his original petition to the Commission.
• In September 2020, the Commission issued an opinion finding that Jarkesy committed antifraud violations and imposing sanctions consisting of a cease-and-desist order, disgorgement and pre-judgment interest, a civil money penalty, and an industry bar. The Commission analyzed each of Jarkesy’s constitutional arguments, but rejected all of them.
• After the Commission issued its opinion, Jarkesy filed a petition for review by the US Court of Appeals for the Fifth Circuit, where he would finally have the opportunity for a federal court to hear his claims that SEC administrative proceedings are unconstitutional.

On May 18, 2022, in a split decision by a three-judge panel, the Fifth Circuit vacated the Commission’s decision and issued a strongly-worded opinion essentially finding that all SEC administrative proceedings are unconstitutional. The preamble to the opinion provides insights into how the Fifth Circuit—or at least the two-judge majority of this particular panel—views the modern administrative state. The court began by stating that the Commission, which has “substantial power to enforce the nation’s securities laws,” frequently “acts as both prosecutor and judge” and issues decisions that have “broad consequences for personal liberty and property.” The court then pointed out that the US Constitution “constrains the SEC’s powers by protecting individual rights and the prerogatives of the other branches of government,” and stated that the present case “is about the nature and extent of those constraints in securities fraud cases in which the SEC seeks penalties.” In the end, the court concluded that the administrative proceeding against Jarkesy “suffered from three independent constitutional defects,” each of which is addressed below.

Jarkesy was deprived of his constitutional right to a jury trial. The Fifth Circuit identified a two-stage process for determining if the right to a jury trial under the Seventh Amendment applies to a particular lawsuit. According to the opinion, a court must first decide whether an action’s claims arise “at common law” under the Seventh Amendment. If so, the court must then decide whether the Supreme Court’s public-rights cases “nonetheless permit Congress to assign it to agency adjudication without a jury trial.”

• For the first stage, the Fifth Circuit found that the claims underlying the SEC’s action against Jarkesy arose at common law. The court pointed out that fraud prosecutions were regularly brought at common law in English courts, and that the Supreme Court has held that actions seeking civil money penalties “are akin to special types of actions in debt from early in our nation’s history which were distinctly legal claims.” As a result, given the Commission’s claim seeking a penalty against Jarkesy, the court found that the action arose at common law. And, the fact that the SEC also sought equitable remedies (an industry bar and disgorgement) “does not invalidate the jury-trial right,” because the “penalty facet of the action suffices for the jury-trial right to apply to an adjudication of the underlying facts supporting fraud liability.”
• For the second stage, the Fifth Circuit noted that the relevant considerations include (i) whether Congress created a new cause of action “unknown to the common law because traditional rights and remedies were inadequate to cope with a manifest public problem,” and (ii) whether jury trials would “go far to dismantle the statutory scheme” or would “impede swift resolution of the claims created by statute.” The court stated that fraud actions under the federal securities laws “echo actions that historically have been available under the common law,” meaning that the SEC’s claims against Jarkesy are not new causes of action unknown to the common law. As for any effect that jury trials would have on the SEC’s claims, the court noted that the Commission is permitted by statute to bring enforcement actions “either in-house or in Article III courts,” meaning that the SEC is experienced in litigating such actions before a jury. The court also stated that “securities-fraud enforcement actions are not the sort that are uniquely suited for agency adjudication,” and “the federal courts have dealt with actions under the securities statutes for many decades.” The court thus found that the SEC’s action against Jarkesy “is not the sort that may be properly assigned to agency adjudication under the public-rights doctrine.”

Accordingly, the Fifth Circuit held that the administrative proceedings before the SEC’s in-house ALJ violated Jarkesy’s right to a jury trial under the Seventh Amendment—and, as such, the Commission’s decision must be vacated.

Congress unconstitutionally delegated legislative power to the SEC. While the Fifth Circuit left the door open as to whether the right to a jury trial applies to different types of claims brought in SEC administrative proceedings, the court reached a separate holding that condemns all such proceedings as unconstitutional. The court found that Congress “unconstitutionally delegated legislative power to the SEC when it gave the SEC the unfettered authority to choose whether to bring enforcement actions in Article III courts or within the agency.” After analyzing several of the Federalist Papers authored by James Madison and the separation of powers provided for by the Constitution, the court concluded that “the legislative power is the greatest of these powers, and, of course, it was given to Congress.” The court then engaged in a lengthy analysis of why Congress cannot delegate powers that are strictly and exclusively legislative to another branch of the government, while also acknowledging that Congress “may grant regulatory power to another entity only if it provides an intelligible principle by which the recipient of the power can exercise it.”

To determine whether Congress has unconstitutionally delegated legislative power, the court set forth two questions: “(1) whether Congress has delegated power to the agency that would be legislative power but-for an intelligible principle to guide its use and, if it has, (2) whether it has provided an intelligible principle such that the agency exercises only executive power.” For SEC enforcement actions, the court noted that “the power to assign disputes to agency adjudication is peculiarly within the authority of the legislative department.” As a result, the SEC’s “ability to determine which subjects of its enforcement actions are entitled to Article III proceedings with a jury trial, and which are not” is clearly “a delegation of legislative power.” The court then noted that “Congress did not provide the SEC with an intelligible principle by which to exercise that power.” Indeed, the court stated that “Congress has said nothing at all indicating how the SEC should make that call in any given case,” and that “a total absence of guidance is impermissible under the Constitution.” Based on this separate and independent holding, and against the backdrop of 88 years of Commission practice, the Fifth Circuit vacated the SEC’s decision against Jarkesy.

Statutory removal restrictions on SEC ALJs are unconstitutional. The Fifth Circuit’s final holding dealt yet another significant blow to the SEC’s ability to initiate and litigate administrative proceedings before its own ALJs. Building on the Supreme Court’s separation of powers reasoning in Free Enterprise Fund, the Fifth Circuit held that “the statutory removal restrictions for SEC ALJs are unconstitutional.”

In Free Enterprise Fund, the Supreme Court found that the structure of the PCAOB violated the Constitution’s separation of powers because (i) PCAOB board members could be removed only “for good cause shown,” which was defined as specific willful violations, after notice and opportunity for a hearing, (ii) this removal authority was vested in the Commission rather than the President, and (iii) the President could only remove SEC Commissioners for “inefficiency, neglect of duty, or malfeasance in office.” Accordingly, in the words of the Fifth Circuit, “the Supreme Court held that this extensive system insulating PCAOB members from removal deprived the President of the ability to adequately oversee the Board’s actions.”

The Fifth Circuit then turned to the question of “whether SEC ALJs serve sufficiently important executive functions, and whether the restrictions on their removal are sufficiently onerous, that the President has lost the ability to take care that the laws are faithfully executed.” The court answered this question in the affirmative, pointing out that (i) SEC ALJs are inferior officers, (ii) they can only be removed by the Commission if good cause is found by the Merits Systems Protection Board (MSPB), and (iii) SEC Commissioners and MSPB members can only be removed by the President for cause. Accordingly, the Fifth Circuit found that “SEC ALJs are insulated from the President by at least two layers of for-cause protection from removal, which is unconstitutional under Free Enterprise Fund.”

In light of the Jarkesy court’s three separate and significant holdings that SEC administrative proceedings are unconstitutional, the Commission is likely to seek rehearing en banc by the entire Fifth Circuit—and, if a majority of the full court follows the split decision of the three-judge panel, it would appear that the Commission would be compelled to petition the Supreme Court to grant certiorari.

Takeaways and Open Questions

In the end, what does this all mean for securities enforcement? Given that constitutional challenges continue to move through the courts, it may be some time before the full effect of the challenges will be known and the uncertainty may linger long after the decisions are rendered. That said, the following are some key takeaways and open questions that both the Commission and respondents in administrative proceedings are surely considering:

• What is the appetite of the Supreme Court to significantly limit the powers of the SEC? The current makeup of the Supreme Court would suggest that constitutional challenges supporting a more limited government and a reduction of the administrative state might have their best chance of success in decades. As a result, respondents who might have been hesitant to invest the resources to engage in such a challenge and stick with it through multiple appeals might now go for it.
• Will the SEC’s current aggressive stance on enforcement affect how respondents handle administrative proceedings? As noted in a recent Advisory, the current leadership at the SEC has taken an aggressive stance on enforcement and has been very active in bringing enforcement actions of all types. In addition, earlier this year, the Commission issued a report asking Congress for budget increases to create 125 additional Enforcement Division positions “to enhance the division’s ability to timely pursue the wide variety of misconduct within the SEC’s remit.” Significantly, more than a quarter of these new positions would be focused on litigation, as it appears that the Commission is gearing up for fewer settlements and more contested actions. Moreover, during settlement negotiations, if the SEC staff insists on sanctions that are incongruent with comparable settled cases from the past, this likely will lead to more litigation—and, if these cases are brought as administrative proceedings, respondents now have more tools to defend themselves by challenging the constitutionality of such proceedings.
• Will the combination of Cochran and Jarkesy lead the SEC to enter into more settlements in pending investigations or administrative proceedings? If the SEC faces a large percentage of respondents in administrative proceedings asking for injunctions from federal district courts, this could create a logistical nuisance, if not a nightmare, for the Commission. Despite the request for 125 additional Enforcement Division personnel, the SEC still has limited resources and will need to pick and choose its battles. Will the Commission and its staff decide that it would be beneficial to show the public that it can still bring settled administrative proceedings with civil money penalties despite the constitutional questions that remain open—and, if so, will this lead to more settlements? This would appear to be contrary to a recent Law360 article reporting that there have been conflicts within the SEC staff based on “Chair Gary Gensler’s approach to enforcement and his drive for more litigation and settlement penalties.” The article also states that, “in contrast to prior SEC leadership, . . . Gensler’s top brass has pushed back more often on settlement proposals, which has produced tensions between the front office and the litigators trying to move cases across the finish line.” Time will tell whether the recent successes of constitutional challenges will affect the Commission’s willingness to agree to more settlements in administrative proceedings.
• Will the SEC shift to bringing more actions in federal court until the landscape for administrative proceedings becomes clearer? There appears to be a public perception that the Commission enjoys a home court advantage in administrative proceedings. For example, in 2015, a Wall Street Journal article reported that, during the period from October 2010 through March 2015, the “SEC won against 90% of defendants before its own judges in contested cases,” which was “markedly higher than the 69% success the agency obtained against defendants in federal court over the same period.” While the data is more nuanced when looking at particular types of actions and their dispositions, it is clear that the Commission engaged in a concerted effort post-Dodd-Frank to increase the number of enforcement actions brought administratively as compared to those initiated in federal court. There could be a number of reasons for this, ranging from the Commission itself having the ability to hear the appeal of an ALJ’s decision to the absence of the need to seek judicial approval of settlements reached after a contested action has been filed. The open question, however, is whether the potential constitutional obstacles created by the recent case developments will cause the Commission to shift back to bringing more federal court actions, even if only temporarily.
• Will constitutional challenges to other types of SEC enforcement actions be brought? While the SEC brought antifraud charges and sought a civil money penalty in the Jarkesy case, the agency deals with other types of cases on a regular basis. These include, by way of example, actions alleging (i) violations of books and records and internal control provisions of the securities laws, (ii) aiding and abetting, causing, and control person violations, and (iii) violations of applicable auditing standards. While the Commission can choose to seek penalties for certain of these actions, it is not required—and it is not uncommon for less serious, non-fraud cases to be resolved without a penalty being imposed. Will respondents in these types of administrative proceedings attempt to apply the Jarkesy holdings and bring constitutional challenges? And, in light of Cochran, will these challenges include the early involvement of the federal courts when respondents seek to enjoin the administrative proceedings?
• Will the constitutional challenges result in new legislation? It remains to be seen whether Congress will need to act based on the recent case developments, but there are scenarios where this might happen. For example, new legislation could be needed if the Supreme Court ultimately were to hear the Jarkesy case and agree with the Fifth Circuit’s holding that SEC administrative proceedings are unconstitutional because Congress did not provide the SEC with an intelligible principle for deciding when to bring enforcement actions administratively. This is not out of the question given that some members of the Supreme Court have indicated that they are interested in revisiting the issue of Congress’s ability to delegate legislative authority. The Court has not invoked the non-delegation doctrine to overturn a federal law since 1935—and, if it revives the doctrine, the SEC would not have the authority to bring any administrative proceedings unless and until Congress passes legislation providing more specific directions as to how the SEC can use its enforcement authority.
• Will the constitutional challenges result in policy changes at the Commission? While the Cochran case is focused on the jurisdictional question of whether respondents in SEC administrative proceedings can seek to enjoin such proceedings in federal court, the underlying constitutional question in that case involves whether the removal restrictions on SEC ALJs are unconstitutional. In Jarkesy, the answer to this question was “yes.” If the Supreme Court were to agree and hold that ALJs are impermissibly protected officers, how will the problem be resolved? It should be noted that the Supreme Court’s decision in Free Enterprise Fund did not result in the end of the PCAOB; instead, the Supreme Court invalidated the statutory removal restrictions for the PCAOB’s members, and the PCAOB issued a release stating that the “consequence of the Court’s decision is that PCAOB Board members will be removable by the SEC at will, rather than only for good cause.” It would appear that a similar fix could be implemented with respect to the SEC’s ALJs. Also, would it help if the staff of the Division of Enforcement were required to request that all putative defendants/respondents address the choice of forum in their responses to Wells notices?
• Will a major securities scandal or adverse market event swing the pendulum of public opinion and result in calls for more aggressive enforcement rather than more limited government? There appears to be a public perception that it is simply unfair for the SEC to act as the investigator, prosecutor, and judge in administrative proceedings. In fact, some would say this perception was reinforced by the Commission’s recent announcement that, for a period of time, administrative personnel in the Enforcement Division accessed memoranda drafted by Adjudication staff because certain databases had mistakenly not been configured to restrict such access. Of course, the calls for a more limited role by the SEC could end quickly. As noted above, several expansions of the SEC’s powers came on the heels of significant securities scandals and adverse market events. While the collective memory of the public can be short, there undoubtedly will be calls for increased enforcement capabilities at the SEC after the next major scandal or if the already uncertain markets take a turn for the worse.

These open questions will need to be answered before there is a clear path forward for SEC administrative proceedings. In the meantime, we are continuing to monitor the various constitutional challenges and developments in the relevant cases. If you have questions about these developments or anything related to the SEC’s enforcement efforts, please reach out to the authors or your regular Arnold & Porter contact.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.