Supreme Court Prohibits Use of Administrative Courts in SEC Fraud Actions

Sven Stricker

In a 6-3 ruling last Thursday, the Supreme Court ruled that defendants are entitled to a jury trial where the Securities and Exchange Commission (SEC) seeks civil penalties for securities fraud claims. The decision effectively overturns the portion of the Dodd-Frank Act authorizing the SEC to impose civil penalties through its own in-house proceedings; instead, the SEC must now pursue civil penalties in federal court because of the “close relationship” between common law fraud and the SEC’s securities fraud regime. 

Background

Between 2007 and 2010, George Jarkesy started two investment funds, raising about $24 million from 120 accredited investors. Patriot28, which Jarkesy managed, served as the funds’ investment adviser. According to the SEC, Jarkesy and Patriot28 misled investors by (1) misrepresenting the funds’ investment strategies, (2) lying about the identity of the funds’ auditor and prime broker, and (3) inflating the funds’ claimed value so that they could collect larger management fees.

The SEC initiated an enforcement action against Jarkesy and Patriot28, seeking civil penalties for alleged violations of the antifraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. Relying on the Dodd-Frank Act, the SEC opted to adjudicate the matter itself rather than in federal court. In 2014, the presiding administrative law judge (ALJ) issued an initial decision. The SEC reviewed this decision and issued its final order in 2020, levying a civil penalty of $300,000 against Jarkesy and Patriot28. 

On appeal, the Fifth Circuit vacated the SEC’s final order, holding the agency’s decision to adjudicate the matter in-house violated Jarkesy’s and Patriot28’s Seventh Amendment right to a jury trial. After the Fifth Circuit denied rehearing, the Supreme Court granted certiorari. 

The SEC’s Action Implicates the Seventh Amendment

Chief Justice Roberts first framed the threshold issue – whether the SEC’s securities fraud claims implicate the Seventh Amendment, which guarantees the right to a jury trial for suits at common law. Because the SEC’s claims are “legal in nature,” the Seventh Amendment applies. 

In arriving at this conclusion, the Court stressed that monetary civil penalties at common law serve retributive or deterrent purposes. And while courts of equity could order a defendant to return unjustly obtained funds, only courts of law issued monetary penalties to “punish culpable individuals.” The Court explained if a civil remedy is designed to punish or deter conduct, it is a type of remedy at common law and can only be enforced in courts of law. 

Per the Court, the SEC’s civil penalty scheme cites these legal considerations, including deterrence and punishment. In sum, the “close relationship” between the SEC’s securities fraud claims and common law fraud implicate the Seventh Amendment and entitled Jarkesy to a jury on the claims. 

Public Rights Exception Does Not Apply

The Court held that the “public rights” exception to the Seventh Amendment did not apply. Here, the Court identified the classes of cases fitting within this exception, including government revenue collection, immigration, and tariffs designed to promote competition. But because the SEC’s securities fraud claims did not fall within any of those well-defined exceptions, the Dodd-Frank Act could not siphon a common law action from an Article III court. 

Another Loss for the SEC 

It will be interesting to follow how the SEC responds to this—whether it be by pursuing civil penalties less often or by pursuing more cases in federal court rather than in-house. This ruling feels like a continuation of efforts to limit the SEC’s ability to take punitive actions. In 2020, in Liu v. Securities and Exchange Commission, No. 18-1501, the Supreme Court limited disgorgement awards to ensure disgorgement was not being used as a penalty but represented actual profits from the fraud net of “legitimate expenses”. However, the SEC has continued to obtain disgorgement awards in the four years since. Having to try a case in federal court seems to be a higher hurdle than the Liu limitations of disgorgement and is likely to have a more meaningful impact on the SEC’s approach to future cases.

This decision also comes on the heels of the Fifth Circuit vacating the SEC’s recently adopted private fund rules, which the SEC designed to enhance compliance rules for private fund investment advisers. Additionally, several private fund industry groups have asked the Fifth Circuit to vacate the SEC’s new short-selling rules, which require investment managers to disclose details about their short positions. We previously outlined the SEC’s adopted Rule 13f-2 here. When the Fifth Circuit issues an opinion in that case, we will provide an update.