The Supreme Court Strips SEC of Fraud-Fighting Forum, Sparking Debate on Broader Implications for Federal Enforcement

For more than a decade, the U.S. Securities and Exchange Commission (the “SEC”) has been able to bring enforcement actions in either federal court or the agency’s internal venue. Not anymore. On June 27, 2024, the U.S. Supreme Court issued a pivotal ruling in the case of SEC v. Jarkesy, significantly curtailing the SEC’s ability to use its administrative proceedings to impose civil penalties for securities fraud. In a 6-3 opinion authored by Chief Justice John Roberts for the conservative majority, the Court agreed with the Fifth Circuit that the SEC’s reliance on in-house tribunals in cases like Jarkesy was unconstitutional. Going forward, the SEC can no longer opt to adjudicate civil fraud suits before its own Administrative Law Judges (“ALJs”). Instead, these cases must be tried in federal District Court, where a defendant’s Seventh Amendment right to a civil jury trial is available. This decision not only alters the landscape for securities fraud enforcement but also signals potential broader implications for the enforcement powers of federal agencies across the government. Coupled with a series of other recent rulings by the Court, this verdict adds to a body of law with potentially far-reaching implications for the enforcement powers of all federal agencies.

The SEC’s Evolving Enforcement Authority: From Courtroom to Administrative Proceedings

Congress originally created the SEC in 1934 to enforce its recently passed laws designed to combat securities fraud and increase market transparency. Originally, the Commission could only seek to impose civil penalties on unregistered investment advisers in federal court, but the SEC’s enforcement authority has evolved significantly over the years through additional legislation. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which granted the SEC’s broader authority to impose monetary civil penalties through its own administrative enforcement proceedings. This expansion enabled the SEC to choose whether to pursue enforcement actions in federal court or adjudicate them internally. The “choice of forum” dictates the procedural rights of defendants and the range of remedies accessible to the SEC.

In federal court, cases involving the SEC follow a structured process: factual determinations are made by a jury,¹ presided over by a life-tenured, salary-protected Article III judge. The litigation adheres to the Federal Rules of Evidence and the ordinary rules of discovery. But when the SEC chooses to adjudicate a matter in-house, significant differences emerge. There are no juries in SEC administrative courts; instead, the SEC or its delegees — typically the ALJs that the SEC employs — preside over the proceedings and finds facts, while the SEC’s Division of Enforcement prosecutes the case. The SEC’s Rules of Practice govern these hearings, and guilt is determined by a preponderance of evidence. If an ALJ presides, the full Commission has the option to review findings and conclusions, though it’s not mandatory.² Appeals from ALJ decisions must be made to the SEC commissioners, and then the SEC’s final decision may be appealed to a federal appeals court.³ But such judicial review is deferential. By law, a reviewing court must uphold the agency’s factual findings if supported by the record, even when they rest evidence that would be inadmissible in federal court, such as hearsay.⁴

The Decision: Constitutional Scrutiny on Agency Authority and Judicial Oversight

Jarkesy case revolves around the SEC’s authority and its ALJs. In 2013, shortly after the enactment of the Dodd-Frank Act, the SEC initi­ated an enforcement action against George Jarkesy and his investment advisory firm, Patriot28 LLC (“Patriot28”). Jarkesy utilized Patriot28 as the investment adviser for his two hedge funds and raised approximately $24 million from 120 accredited investors, a group that includes financial institutions, investment professionals, and high-net-worth individuals. The SEC’s allegations against Jarkesy and Patriot28 focus on violations of federal securities laws’ “antifraud provisions.”⁵ Specifically, they are accused of misrepresenting their investment strategies, making false claims about the funds’ auditor and prime broker, and overvaluing fund assets to increase fees charged to investors.

The SEC opted for an in-house adjudication before an ALJ, who initially ruled that Jarkesy and Patriot28 were guilty of securities fraud. The SEC reviewed the decision and released its final order in 2020. The final order levied a civil penalty of $300,000 on Jarkesy and Patriot28, directed them to cease and desist from committing or causing any violations, and barred Jarkesy from most of the securities industry. Patriot28 was also ordered to disgorge approximately $685,000 in what the SEC termed as “ill-gotten gains.” Jarkesy and Patriot28 petitioned for judicial review. A divided panel of the Fifth Circuit sided with them based on three grounds: the SEC’s adjudication of the matter in-house deprived Jarkesy of his Seventh Amendment right to a jury trial, unconstitutional delegation of legislative power to the SEC, and violation of the “Take Care” clause due to the removal restrictions on SEC ALJs.

The Supreme Court affirmed the Fifth Circuit’s decision on the Seventh Amendment ground alone. The Court emphasized that the right to trial by jury is of such importance that any seeming curtailment of the right should be scrutinized with the utmost care. Central to the Court’s decision was the classification of statutory claims seeking legal remedies, such as civil penalties, as falling squarely within the domain of common law courts. The Court clarified that the constitutional right of trial by jury is not limited to the common-law forms of action recognized when the Seventh Amendment was ratified. It includes statutory claims that are legal in nature.

In this case, the SEC sought civil penalties for the respondents’ alleged fraud. The Court determined that such relief is indeed “legal in nature” when it is designed to punish or deter the wrongdoer rather than solely to restore the status quo. The justices held that such claims, due to their nature and historical treatment in legal practice, merit adjudication in Article III courts with the right to a jury trial unless specific criteria for the “public rights” exception are met. This exception allows certain matters to be adjudicated by administrative agencies without a jury, but only under narrow circumstances not applicable to the securities fraud case at hand.

“A defendant facing a fraud suit has the right to be tried by a jury of his peers before a neutral adjudicator,” Chief Justice Roberts wrote. He underscored that the SEC cannot simultaneously act as prosecutor, judge, and jury, stating, “That is the very op­posite of the separation of powers that the Constitution demands.”

Justice Sonia Sotomayor, joined by Justices Elena Kagan and Ketanji Brown Jackson, authored a heated dissent and read the summary from the bench. She characterized the majority’s decision “a massive sea change” that would unleash “chaos.” Justice Sotomayor criticized the ruling as a “power grab” and a “devastating blow” to effective governance, warning that it could jeopardize numerous other laws — “the constitutionality of hundreds of statutes may now be in peril, and dozens of agencies could be stripped of their power to enforce laws enacted by Congress.”

Justice Neil Gorsuch also wrote a concurrence in which he delved deeply into the history of the Constitution and the American legal system. He characterized the dissent’s “broad and unqualified” interpretation of the public rights exception doctrine as “astonishing.” Justice Clarence Thomas joined both the majority opinion and Justice Gorsuch’s concurrence.

Immediate Implications on the SEC

While the Jarkesy ruling may have broad effects on administrative power throughout the United States, its immediate effect on the SEC is likely to be limited. Due to the many challenges made to the SEC’s power to use administrative courts that emerged quickly after the passage of Dodd-Frank, the SEC has not filed litigated fraud cases in its own administrative courts for many years. Any case currently litigated a fraud charge is likely already in a federal district court.

However, administrative proceedings are frequently used to file settled fraud cases that often come with large civil penalties. Most defendants prefer the administrative forum for a settlement because it gives the parties more control over the proceedings and actions can be initiated and settled in the same day. A close reading of the ruling does not appear to curb the SEC’s ability to file settled actions in administrative proceedings, though the SEC may amend its current settlement practices to mitigate any perceived risk to its upcoming cases.

Future Implications on Administrative Power

While the ruling itself is narrowly focused on the SEC, this decision could bolster efforts to revive the nondelegation principle, which has languished in recent years. By affirming that the SEC’s in-house adjudication of fraud claims violated the Seventh Amendment right to a jury trial, the decision carries profound implications for other administrative agencies wielding similar in-house adjudication powers. Furthermore, beyond the immediate impact on imposing civil penalties, the ruling raises broader questions about regulatory agencies’ authority over what the court terms “private rights.” As Justice Sotomayor pointed out, Congress has authorized over 200 statutes empowering numerous agencies to levy civil penalties for violations of statutory obligations. There is a much larger swath of agencies, including the Occupational Safety and Health Administration, the Environmental Protection Agency, the Department of Labor, and the Social Security Administration, which employs a roster of 1,500 ALJs that see roughly 700,000 cases annually.

¹ See U. S. Const., Amdt. 7.

² See §201.360; U. S. C. §78d–1.

³ See §§77i(a), 78y(a)(1), 80b– 13(a).

⁴ See §§201.320, 201.326.

⁵ The “antifraud provisions” refer to the relevant provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940, which respectively govern the registration of securities, the trading of securities, and the activities of investment advisers.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.