In “Seismic Shift,” Supreme Court Strips SEC of Ability To Seek Civil Penalties for Securities Fraud in Administrative Proceedings

Introduction

In a term packed with landmark rulings, the U.S. Supreme Court held that the Seventh Amendment to the U.S. Constitution entitles a defendant to a jury trial when the U.S. Securities and Exchange Commission (the SEC or the Commission) charges securities fraud and seeks civil penalties pursuant to Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, or Section 206 of the Investment Advisers Act of 1940. See Securities & Exchange Commission v. Jarkesy, No. 22-859, 603 U.S. _____, slip op. (2024).¹ As a result, these claims cannot be brought in an SEC administrative proceeding, but rather must be brought in a federal court.

This long-awaited decision has significant implications for the SEC, which has utilized administrative proceedings throughout its 90-year history and has sought civil penalties in those proceedings since Congress authorized such relief in the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.²

In addition, dozens of other federal agencies that impose civil penalties in administrative proceedings may now find themselves subject to constitutional challenges in which hundreds of statutes empowering federal agencies to impose civil penalties may be called into question. For instance, Justice Sotomayor dissented and referred to the Jarkesy decision as a “massive sea change,” citing to “more than two dozen agencies that can impose civil penalties in administrative proceedings” that could be affected by the decision including the Commodity Futures Trading Commission, the Department of Agriculture, the Department of Justice, the Consumer Financial Protection Bureau, the Federal Energy Regulatory Commission, the Department of Education, the Department of Health and Human Services/Food and Drug Administration, the Occupational Safety and Review Commission, the Environmental Protection Agency, and others.

The Majority Opinion

For the majority, the case presented a “straightforward” question of “whether the Seventh Amendment entitles a defendant to a jury trial when the SEC seeks civil penalties against him for securities fraud.” Op. 6. The Court first held that the “SEC’s antifraud provisions replicate common law fraud, and it is well established that common law claims must be heard by a jury.” Op. 6. The Court then held that the “public rights” exception “does not apply here because the present action does not fall within any of the distinctive areas involving governmental prerogatives where the Court has concluded that a matter may be resolved outside of an Article III court, without a jury. The Seventh Amendment therefore applies and a jury is required.” Op. 6-7.

In finding that the Seventh Amendment applies, Chief Justice Roberts’ opinion reasoned that “the remedy is all but dispositive.” Op. 9. Because civil penalties are a form of monetary relief that is punitive (as compared to being compensatory in nature) they are “a type of remedy at common law that could only be enforced in the courts of law.” Op. 11. According to the majority, this conclusion is reinforced by the “close relationship” between the antifraud provisions of the federal securities laws and common law fraud, which target the same conduct and are grounded in similar vocabulary and principles. Op. 11.

In finding that the “public rights” exception does not apply, the Court acknowledged that, “Our opinions governing the public rights exception have not always spoken in precise terms … [and this] is an ‘area of frequently arcane distinctions and confusing precedents.’” Op. 17. Here, the Court focused on whether the underlying dispute concerns “private rights [which] may not be removed from Article III courts,” such as “a suit [] in the nature of an action at common law….” Op. 14. The Court distinguished these private, common law claims, such as fraud, from “a class of cases concerning what we have called ‘public rights’ … [which] ‘historically could have been determined exclusively by [the executive and legislative] branches.’” Op. 14.

By way of example, the majority observed that “public rights” have been found in the areas of revenue collection, foreign commerce, immigration, relations with Native American tribes, administration of public lands, public benefits, pensions, and patent rights. By contrast, the Court concluded that: “A defendant facing a fraud suit has the right to be tried by a jury of his peers before a neutral adjudicator. Rather than recognize that right, the dissent would permit Congress to concentrate the roles of prosecutor, judge, and jury in the hands of the Executive Branch. That is the very opposite of the separation of powers that the Constitution demands.” Op. 27.

The Dissent

In an unusual step, Justice Sotomayor read portions of her 40-page dissent (which Justices Kagan and Jackson joined) from the bench on the day the decision was announced. She asserted the majority wrongly decided for the first time that “Congress violated the Constitution by authorizing a federal agency to adjudicate a statutory right that inheres in the Government in its sovereign capacity, also known as a public right.” Dissent 1-2.

Claiming that “Congress had no reason to anticipate the chaos today’s majority opinion would unleash after all these years,” the dissent reframed the issue not as a Seventh Amendment issue, but as an Article III separation-of-powers one. Dissent 1. In Justice Sotomayor’s view, “Congress identified a national problem, concluded that existing legal remedies were inadequate to address it, and then created a new statutory scheme that endorsed Executive in-house enforcement as a solution.” Dissent 13. Rather than the “I know when I see it” approach the dissent claims the majority took, the dissent argues prior precedent mandates a different approach: “When a claim belongs to the Government as sovereign, the Constitution permits Congress to enact new statutory obligations, prescribe consequences for the breach of those obligations and then empower federal agencies to adjudicate such violations and impose the appropriate remedy.” Dissent 8.

The Impact of Jarkesy on the SEC and Its Division of Enforcement

Jarkesy is one of the most significant Supreme Court decisions in the SEC’s 90-year history and continues a series of losses by the SEC before the Supreme Court in recent years. Last term, in Axon Enterprise, Inc. v. FTC, 598 U.S. 175 (2023) (and its companion case SEC v. Cochran), the Court held that a respondent in an SEC administrative proceeding may collaterally attack the constitutionality of the proceeding in federal district court rather than appeal an administrative decision to the Commission before petitioning a federal appellate court for review. Taken together, these decisions have steadily eroded the power and authority of the Commission and raise significant questions about how its use of administrative proceedings fits within its enforcement program going forward, and its approach to enforcement remedies more broadly.

Looking forward to what may be on the horizon in light of these decisions:

• Reverting to Pre-Dodd Frank Penalty Practice — A Shift Back to Federal Court. In light of the threats posed by Cochran and Jarkesy, going forward, the Division of Enforcement will likely continue its recent practice of filing all enforcement actions charging fraud and seeking financial penalties in federal district court.
• The Future of the SEC’s Administrative Proceedings. The Jarkesy decision addresses only a subset of administrative enforcement actions authorized by the Commission and instituted by the Division of Enforcement. The Commission can still authorize administrative or cease and desist proceedings charging violations of the federal securities laws or the Commission’s Rules of Practice while seeking other remedies that are not “legal in nature,” such as censures, associational bars, officer and director bars, and disgorgement. It may, however, only be a matter of time until these remedies are challenged along the lines of Cochran and Jarkesy.
• What Will Settlements Look Like Going Forward? While Jarkesy does not address the Commission’s authority to impose civil penalties where a party under investigation voluntarily agrees to settle fraud-based charges with the SEC through an administrative proceeding, the Court’s decision seems likely to be a significant point of leverage during future settlement discussions with the Division of Enforcement. This could have profound implications for the Division of Enforcement’s senior leadership who oversee the Commission’s enforcement docket, given that currently there are over 200 administrative cases open (almost all of which involve a demand for the imposition of civil penalties) and the SEC no doubt has many more at various stages of resolution.
• Will Enforcement’s Aggressive Approach Be Tempered? Unlikely. The Division of Enforcement will continue to pursue antifraud cases seeking penalties in federal district court. Following the Jarkesy decision, Gurbir Grewal, the Director of the Division of Enforcement issued a statement that, “The SEC will continue to protect investors and enforce the federal securities laws, including by filing actions in federal court,” adding that, “during the last several years, the SEC has successfully enforced the federal securities laws in federal court, obtaining favorable jury verdicts and dispositive motion rulings in highly contested matters with industrywide implications.”
• Future Constitutional Challenges by Respondents. In light of the Cochran and Jarkesy line of recent cases, respondents may be more emboldened to dedicate resources to such challenges than in the past, given the Court’s receptiveness to structural limitations on administrative actions.

The Broader Ramifications of Jarkesy

Jarkesy is only one of the cases this term impacting the administrative state. In the aftermath of Jarkesy, civil penalty statutory regimes will be challenged, including those identified in the dissent, and it may be difficult to meaningfully distinguish many of them from the SEC’s administrative regime. That said, agency administrative proceedings may remain in place to the extent that they do not have clear analogues at common law or otherwise fit within the public rights exception areas that the majority recognized.

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Please reach out to any author of this Advisory or your regular Arnold & Porter contact for more detail about the cases discussed in the Advisory, and their significance. We will continue to monitor and report on developments as they occur, and to analyze best practices for our clients.

* Pilar Martinez, a summer associate in Arnold & Porter’s Chicago office, contributed to this Advisory.

© Arnold & Porter Kaye Scholer LLP 2024 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.