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Appeals Court Undercuts Agency Enforcement in SEC Fraud Case

May 20, 2022, 9:00 AM

The Fifth Circuit fired a double-barreled blast at federal agency enforcement powers with its ruling that the SEC violated a hedge fund manager’s right to a jury trial by putting his case before an in-house judge.

The U.S. Court of Appeals for the Fifth Circuit’s decision May 18 broadened the legal test for determining which agency actions are barred from being decided by administrative law judges, potentially limiting government litigation strategy, sidelining expert in-house judges, and hamstringing enforcement altogether for agencies that can’t go directly to court, legal scholars said.

The court also blocked the US Securities and Exchange Commission’s administrative adjudication based on a second independent legal theory—one that could put a wide slate of agency powers on the chopping block, the scholars said.

“This very bold, radical, activist decision to hold unconstitutional provisions of a New Deal-era administrative agency’s enforcement regime has potential implications across the government,” said Catherine Fisk, a law professor at University of California-Berkeley. “It’s staggering.”

The ruling dealt a blow to the federal agency enforcement powers in the Fifth Circuit’s jurisdiction, which includes Texas, Louisiana, and Mississippi. It’s unclear whether the Biden administration will appeal to the full appeals court or the US Supreme Court, where a similar ruling would broaden the impact.

The appeals court in its decision overturned the SEC’s judgment against hedge fund manager George Jarkesy and investment adviser Patriot28 LLC.

Jury-Trial Right

The circuit court said the Seventh Amendment guarantees Jarkesy and Patriot28 a trial by jury because the securities fraud charges were akin to claims that arose under the common law before the amendment’s ratification. Fraud prosecutions were regularly brought in English courts, the court said.

That holding expanded the test for what agency actions trigger the right to a jury trial by using the word “akin,” which allowed the court to analogize 20th century securities regulation to 18th century fraud prosecution, legal scholars said.

That expansion could drive lawsuits citing centuries-old common law to challenge administrative adjudication at many agencies, including the National Labor Relations Board, Federal Trade Commission, and Labor Department sub-agencies.

While making that link between common law claims and agency enforcement in the SEC context means the agency will have to go to court, the consequences would be “draconian” for agencies like the NLRB that can only litigate complaints before administrative law judges, said Richard Pierce, an administrative law professor at George Washington University.

“The consequence for the NLRB would be it simply can’t adjudicate any of its disputes anywhere,” Pierce said.

Delegation Problem

In its second holding, the Fifth Circuit said that Congress unconstitutionally delegated its power by permitting the SEC to pick whether to pursue enforcement cases in federal courts or internally.

That forum selection wasn’t just prosecutorial discretion, but rather legislative power that didn’t come with guidance from Congress on how the SEC should exercise its discretion, the court said.

The ruling is a wide-reaching version of the nondelegation doctrine, a legal theory that the Supreme Court hasn’t used since 1935 but which has been gaining steam in conservative legal circles in recent years as a potential weapon against agency power, legal scholars said.

Agency power under other statutes would be at risk if the Fifth Circuit’s nondelegation doctrine holding is taken literally, said Ilan Wurman, an administrative law professor at Arizona State University.

The ruling chips away at the “bedrock principle” that an agency can choose to make policy by adjudicating cases or going through formal rulemaking process, said David Zaring, a professor of legal studies at the Wharton School at the University of Pennsylvania. It also could reach broadly into agency discretion over when and whether to enforce a law, he said.

While the ruling on the nondelegation doctrine could limit federal agencies’ enforcement choices, it’s not something that the Supreme Court would likely uphold, said Nina Mendelson, an administrative and environmental law professor at the University of Michigan.

“Even for a court with members who are quite interested in strengthening the nondelegation doctrine, I think this extension of it would probably be a bridge too far for the court,” Mendelson said.

The circuit court also held that restrictions on the removal of the SEC’s administrative law judges are unconstitutional. The high court recently agreed to take a case on a procedural issue related to challenging the constitutionality of ALJ’s removal protections.

SEC Impact

An SEC spokesperson said after the ruling that it’s assessing the decision and working with the Justice Department on next steps.

The opinion is unlikely to change how the SEC litigates new cases, because the number of in-house matters has dropped sharply since the Supreme Court’s 2018 ruling that the agency’s judges had been unconstitutionally appointed, said Urska Velikonja, a Georgetown University Law Center professor who studies the agency’s enforcement activity.

But the SEC still must contend with any pending administrative law judge cases.

“The open cases are always a headache,” Velikonja said. “They may have to be refiled in court and relitigated.”

Sidelining the agency’s in-house court also could hurt accused securities law violators, said Kurt Wolfe, of counsel in the SEC enforcement practice at Quinn Emanuel Urquhart & Sullivan LLP. The in-house court can be quicker and cheaper for the subjects of the SEC’s enforcement actions and allow them to resolve cases more quietly than in a federal court, Wolfe said.

“There are an awful lot of defendants in SEC enforcement actions that quite happily will have their case heard by an ALJ,” Wolfe said.

—With assistance from Andrea Vittorio

To contact the reporters on this story: Robert Iafolla in Washington at riafolla@bloomberglaw.com; Andrew Ramonas in Washington at aramonas@bloomberglaw.com

To contact the editors responsible for this story: Keith Perine at kperine@bloomberglaw.com; Martha Mueller Neff at mmuellerneff@bloomberglaw.com