Categories & Search

Pair of Legal Developments leave SEC In-House Legal Courts in Crosshairs

A pair of recent legal developments cast doubt on the long term ability of the Securities and Exchange Commission (“SEC”) to try contested actions before the agency’s in-house administrative law judges (“ALJ”).  First, the Supreme Court accepted a petition to hear the matter of SEC v. Cochran, Petition No. 21-1239, which concerns whether the SEC’s ALJs are unconstitutionally protected from removal. Second, the U.S. Court of Appeals for the Fifth Circuit issued an opinion holding that (1) a respondent in an SEC administrative proceeding was deprived of his right to a jury trial; (2) that Congress unconstitutionally delegated legislative powers to the SEC by failing to provide it with an intelligible principle by which to exercise its delegated power, and (3) that the administrative law judges were unconstitutionally protected from removal. These developments could have long term implications not only for the SEC, but for all federal administrative agencies.

The Supreme Court Agrees to Consider Whether ALJs are Unconstitutionally Insulated from Removal

SEC v. Cochran[1] concerns an appeal from a decision issued by the Fifth Circuit, which held that a respondent in an SEC administrative proceeding can pursue a constitutional challenge to the SEC’s ALJs in federal district court without first completing the administrative appeals process. The decision follows a 2018 ruling from the Supreme Court in Lucia v. SEC, which held that SEC ALJs are officers of the United States under the Appointments Clause of the Constitution, and thus must be appointed by the President, a court of law, or a department head.  Cochran v. SEC, 20 F. 4th 194, 198 (5th Cir. 2021) (citing Lucia v. SEC, 138 S. Ct. 2044 (2018)). The ALJ who presided over the administrative proceeding against Lucia had been appointed by SEC staff members, and was thus deemed unconstitutionally appointed under the Court’s ruling. Lucia, however, left open a separate but related question of whether ALJs are unconstitutionally insulated from the President’s removal powers under Article II of the Constitution.

The question of removal of ALJs is now squarely before the Supreme Court in SEC v. Cochran. Cochran, the subject of an enforcement action filed by the SEC in an administrative proceeding, sued to enjoin the proceeding on the grounds that the ALJ presiding over her case was unconstitutionally insulated from removal.  Cochran’s claim was dismissed by the district court for lack of subject-matter jurisdiction, and a federal court of appeals affirmed the dismissal.  Following an appeal before a full panel, the Fifth Circuit held that the district court was not divested of jurisdiction to hear Cochran’s challenge to the constitutionality of the ALJ.

The SEC filed a petition for cert with the Supreme Court, arguing that the Fifth Circuit’s ruling creates a circuit split, wherein the Second, Fourth, Seventh, Eleventh and D.C. Circuits all reject attempts to bypass the statutory review scheme by seeking injunctions in federal court before the administrative appeals have been exhausted. The petition was granted on May 16, 2022.

The Fifth Circuit Rules that a Respondent in an SEC Administrative Proceeding was Denied his Right to a Jury Trial under the Seventh Amendment of the Constitution

Jarkesy v. SEC is another recent consequential decision from the Fifth Circuit.[2]  In that case, an SEC ALJ found the respondent liable for securities fraud and ordered various remedies, including penalties, and the SEC affirmed the decision on appeal.  The respondent then raised several constitutional challenges to the SEC’s enforcement proceedings. 

The Court agreed with the respondent’s arguments.  First, the Court held that the respondent was unconstitutionally deprived of his right to a jury trial.  The issue, in the Court’s view, turned on whether the SEC’s action against the respondent solely concerned “public rights” –i.e., rights created by statutes within the power of Congress to enact—and for which there is no requirement of a trial before a jury.  In this case, however, the Court found that by pursuing a claim of fraud against the respondent before an ALJ, and by seeking penalties against him, the SEC was not solely vindicating public rights—it was pursuing a traditional legal claim that stemmed from common law, and therefore violated the respondent’s Seventh Amendment right to a jury trial. 

The respondent also took aim at Congress’s delegation of legislative authority to the SEC to determine whether to bring a securities fraud enforcement action in Article III courts or within the agency. The Court again agreed with the respondent, finding that Congress had unconstitutionally delegated its legislative authority to the SEC, by leaving it to the SEC to determine when and under what circumstances it could commence an action in an administrative proceeding, rather than in federal court. Finally, the Court accepted the respondent’s argument that the ALJs were unconstitutionally insulated from removal, the same issue now before the Supreme Court in SEC v. Cochran.

The Implications for the Future of Administrative Proceedings

These two cases represent the continuation of a multi-year effort to chip away at the constitutional authority of administrative law judges. Respondents in administrative proceedings often contend that the proceedings are biased in favor of the SEC, because the ALJs are employees of the SEC.  Consequently, in contested matters, respondents generally prefer to litigate their claims in federal court.  The SEC, on the other hand, prefers to have the option to litigate in administrative proceedings, because discovery tends to be more limited, and the timeline for reaching a decision is much more expedited than in federal court. 

As a practical matter, however, a decision against the SEC in Cochran is unlikely to have a significant impact on how the SEC approaches contested enforcement matters.  Since the decision in Lucia in 2018, the SEC has filed virtually all contested proceedings in federal district courts, a practice that would likely continue should Cochran prevail before the Supreme Court.  For the SEC to resume its practice of bringing contested matters in administrative proceedings, the SEC, in conjunction with the federal executive branch, would need to develop a solution to the removal issue, by giving the executive branch greater authority to remove an ALJ.

Jarkesy, on the other hand, could be a more consequential case if the holdings are ultimately affirmed by the Supreme Court.[3]  An affirmation of the decision would almost certainly mean that the SEC can no longer pursue fraud claims, or any claims involving penalties, in administrative proceedings.  In such a scenario, the utility of administrative proceedings would effectively become limited to settled matters, or those matters where a respondent expressly consents to litigate before an ALJ, and expressly waives their constitutional challenge to legitimacy of the administrative proceeding.

There are reasons why a respondent may opt to defend an administrative proceeding rather than a federal court action.  First, defending administrative proceedings tend to be less expensive than federal court matters.  Second, as mentioned, decisions in administrative proceedings are usually rendered more quickly than in federal court.  Third, by litigating in an administrative proceeding, a respondent would not be waiving their rights to appeal the merits of the action: they would only be waiving their right to appeal the constitutionality of the proceeding.

But a holding that Congress has unconstitutionally delegated its legislative authority to the SEC could have broad ramifications for the entire administrative state: that holding would call into question whether the SEC and other administrative agencies can engage in independent rulemaking, let alone pursue enforcement actions through administrative proceedings. Indeed, many SEC actions are predicated on rules promulgated by the SEC, not by Congress. Thus, an adverse decision against the SEC based on the “non-delegation theory” could have profound implications for the enforcement authority of the SEC and all other federal administrative agencies.

This blog will continue to monitor and report on any significant updates on these cases.

[3] For the moment, the holding of Jarkesy only implicates courts in the Fifth Circuit—Texas, Louisiana and Mississippi. It remains to be seen whether the SEC will appeal this decision, and risk an adverse decision from the Supreme Court.