Supreme Court Bars Use of SEC In-House Courts for Major Securities Fraud Cases

In SEC v. Jarkesy, the Supreme Court dealt a seismic blow to the SEC’s use of in-house Administrative Law Judges (“ALJs”) for major cases, by holding that when the SEC seeks civil penalties for securities fraud, the Seventh Amendment entitles the defendant to a jury trial.  This bars the SEC from using in-house ALJ actions to gain a home-court advantage in major cases alleging securities fraud, where a defendant’s entire career or business is at stake.  The Jarkesy ruling makes it harder – and more costly – for the SEC to win securities fraud cases, and gives securities fraud defendants the protection of a jury of their peers.

In Jarkesy, the SEC alleged that an investment adviser and its manager (Mr. Jarkesy) violated federal securities laws by misrepresenting investment strategies and the identities of the auditor and prime broker for investment funds, and by inflating the funds’ value to collect higher management fees.  The SEC assessed $300,000 in civil penalties, ordered disgorgement, and permanently barred Mr. Jarkesy from the securities industry and penny stock offerings.  The Fifth Circuit Court of Appeals vacated the SEC’s order, teeing up the case for Supreme Court review.

The Supreme Court held that the Seventh Amendment right to a jury trial in civil cases covers actions alleging violations of the SEC’s antifraud provisions because such actions replicate common law fraud claims, which are traditionally tried before a jury.  First, the Court emphasized that the “right to trial by jury is ‘of such importance and occupies so firm a place in our history and jurisprudence that any seeming curtailment of the right … should be scrutinized with the utmost care.’”[1]  Second, the Court held that the Seventh Amendment applied to fraud claims seeking civil penalties, which are “legal in nature,” because civil penalties assessing money damages seek the “the prototypical common law remedy.”[2]  Critically, the Court held that damages are punitive, increasing along with the severity of the offense, which indicates a legal remedy, rather than a compensatory (equitable) remedy that could fall outside the Seventh Amendment.  Third, the Court reasoned that the close relationship between securities fraud claims under federal securities laws and common law fraud confirmed that such cases are legal in nature.

Next, the Court held that securities fraud claims do not fall within the “public rights” exception to the right to a jury trial in civil cases.  The “public rights” exception applies to permit summary, non-jury proceedings to decide cases seeking the collection of customs, tariffs, or revenue owed to the Treasury, or for penalties for violating statutes in areas where Congress has plenary authority (i.e. immigration, Native American relations, “administration of public lands,” and the “granting of public benefits”).[3]  But the Court rejected the “public rights” exception, and the argument that the SEC’s antifraud provisions originated in a congressionally fashioned regulatory scheme.  The Court held that “what matters is the substance of the action,” and the SEC’s imposition of punitive monetary damages for “the same basic conduct as common law fraud” translates into a private right implicating the Seventh Amendment’s jury trial requirement.[4]  The Court noted that it reached the same result for fraudulent conveyance claims in Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989).  It held that Granfinanciera required applying the Seventh Amendment here.

In contrast, the dissenting Justices argued that a public right arises wherever the government is a party to the dispute, and a public right may always be assigned to an agency.  They argued that in enforcing the securities laws, the SEC responds to violations “committed against the United States rather than an aggrieved individual,” and is therefore enforcing a public right.[5]  Congress did not merely “repackage a common-law claim” in enacting the securities laws, but created a new right that “belongs to the public and inheres to the Government in its sovereign capacity.”[6]  The dissent argued that each time the Supreme Court reviewed government enforcement of a “new statutory obligation through the administrative imposition of civil penalties or fines,” the Court sustained enforcement outside of Article III.[7]  They cited Atlas Roofing Co. v. Occupational Safety and Health Comm’n, a 1977 case in which the Supreme Court had found a public rights exception concerning the use of administrative law judges to enforce the Occupational Safety and Health Act of 1970.  But the majority distinguished Atlas Roofing as involving novel claims that had not been “borrow[ed] … from the common law” – as is the case with federal securities fraud claims.[8]

The Jarkesy ruling will make it more costly for the SEC to pursue major securities fraud claims – and make the SEC less likely to win.  Securities fraud civil actions in federal court involve more extensive document discovery and depositions, which are not usually available in SEC ALJ in-house proceedings.  Further, the process of picking and presenting arguments and legal instructions to a jury makes a federal civil action more time and cost-intensive than an administrative proceeding before an ALJ.

For good reason, the use of ALJs has long been criticized by the financial services community.  Data from when the SEC began bringing larger cases before ALJs showed that the SEC won 90% of cases in ALJ in-house actions, compared to just 69% of its cases in federal Court.[9]  Although the SEC has had high-profile losses before ALJs – including one case handled by our firm – the SEC has generally done better in ALJ in-house actions than in federal court.

What remains to be seen is whether the Jarkesy decision will cause the SEC not to use ALJ in-house courts for securities fraud cases that only seek disgorgement (return of profits) and/or a bar from the securities industry.  But because the SEC typically seeks civil penalties when seeking such other remedies, the Jarkesy ruling will significantly limit the SEC’s use of ALJ proceedings for securities fraud cases going forward.  The loss of home-court advantage in securities fraud cases seeking civil penalties, coupled with the additional costs and uncertainties associated with a jury trial, will likely change the SEC’s calculus regarding prosecution and settlement of these types of claims.

Sadis & Goldberg specializes in counseling fund advisors and litigating on their behalf.  We are available to discuss all matters related to fund formation, management, and litigation, including SEC enforcement actions.  If you have any questions about the Jarkesy decision, an SEC enforcement action, or any related issue, please contact Douglas Hirsch (dhirsch@sadis.com), Sam Lieberman (slieberman@sadis.com), or Frank Restagno (frestagno@sadis.com).