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The SEC’s Administrative Law Judges Under Fire

October 12, 2022

/Management Liability/D&O

In addition to creating rules that govern both private and public companies, the Securities and Exchange Commission (SEC) uses an in-house, government legal system—Administrative Law Judges (ALJs)—to prosecute securities violations. Which cases does the SEC send to ALJs versus into the normal federal court system in front of an Article III judge? It’s up to the SEC’s discretion.

SEC shield building

Notably, the SEC has an aggressive enforcement arm. For example, consider its activities vis a vis its latest illegal insider trading theory concerning “shadow trading.”

Some say that the SEC has been opportunistic in its use of ALJs. In 2015, for instance, an analysis found that the SEC won 90% of the time using ALJs but only 69% in federal court.

Now two recent federal court decisions, both in May 2022, question the constitutionality of the ALJ process.

First, the US Supreme Court agreed to hear a case that deals with whether district courts can consider claims that challenge the constitutionality of the ALJ process in SEC v. Cochran.

Then, the US Court of Appeals for the Fifth Circuit found constitutional violations in the SEC’s ALJ process in Jarkesy v. SEC.

SEC v. Cochran

In 2016, the SEC brought an administrative action against CPA Michelle Cochran for her role at a small accounting firm that allegedly failed to comply with Public Company Accounting Oversight Board auditing standards.

In 2017, the ALJ found her liable, fined her $22,000, and barred her from practicing accounting before the SEC for five years. Cochran objected. However, before the SEC ruled on her objection, the Supreme Court ruled that the way ALJs were appointed was unconstitutional in Lucia v. SEC.

In Lucia v. SEC, the Supreme Court found that ALJs at the time were improperly appointed. Specifically, they are “Officers of the United States” subject to the Appointments Clause of the US Constitution. As such, the ALJs must be appointed by certain parties enumerated in the Constitution (the President, a court of law, or head of a department). None of these parties had appointed the ALJs.

The SEC responded by saying that everyone with pending enforcement proceedings, including Cochran, would be re-tried under new, properly appointed ALJs.

In a federal district court, Cochran filed to stop the proceedings, citing that the re-appointed ALJs would still be improper because the President of the United States could not effectively remove them.

The district court dismissed Cochran’s claim for lack of jurisdiction. Cochran appealed to the Fifth Circuit, which held that the district court did have subject-matter jurisdiction. As it stands today, the Supreme Court has agreed to review the case. Argument is set for Monday, November 7, 2022.

Jarkesy v. SEC

George Jarkesy, Jr. established two hedge funds that brought in more than 100 investors and held about $24 million in assets.

The SEC launched an investigation into Jarkesy’s investing activities in 2011. The SEC ultimately brought an administrative action against Jarkesy and a related party, citing fraud under the Securities Act, the Securities Exchange Act, and the Advisers Act.

The defendants sued in a US District Court in the District of Columbia to stop the ALJ proceedings, stating that the proceedings violated Jarkesy’s constitutional rights. Both the district court and later the US Court of Appeals for DC denied the defendants’ motion.

The ALJ proceedings ultimately found the defendants liable, which resulted in a cease and desist, a civil penalty of $300,000, disgorgement of $685,000 in ill-gotten gains, and a ban from various securities activities.

The defendants appealed the case in the Fifth Circuit, and the court vacated the ALJ’s and the SEC’s securities fraud conviction. Instead, the court found that:

  • The ALJ proceedings violated the petitioner’s Seventh Amendment right to a jury trial.
  • Congress unconstitutionally gave legislative power to the SEC by giving full discretion for forum choice regarding enforcement actions.
  • The statutory removal restrictions on SEC ALJs violate the President’s removal power.

Right to a Jury Trial

The court found that the AJL proceedings against the defendants violated their right to a jury:

The Seventh Amendment guarantees Petitioners a jury trial because the SEC’s enforcement action is akin to traditional actions at law to which the jury-trial right attaches. And Congress, or an agency acting pursuant to congressional authorization, cannot assign the adjudication of such claims to an agency because such claims do not concern public rights alone.

In other words, under the US Constitution, individuals have a right to a trial by jury for things that have always been considered crimes (“common law”) and for which there have been traditional remedies. Fraud falls squarely in the bucket. The mere fact that an administrative agency oversees a type of fraud, here securities fraud, does not change the analysis. If an administrative agency was overseeing a new type of wrongdoing, there may be a public right that justifies suppressing the right to a jury trial—but fraud isn’t new.

Unconstitutional Delegation of Legislative Authority to the SEC

Administrative agencies, which fall under the executive branch of the U.S. government, exist to carry out laws passed by Congress. However, as the court noted, “the Constitution … provides strict rules to ensure that Congress exercises the legislative power in a way that comports with the People’s will.” And that “accountability evaporates if a person or entity other than Congress exercises legislative power.”

In other words, Congress has a job to do—legislate—and it cannot ask an administrative agency to do its job for it. Congress has to provide principles and guidelines when it delegates authority, but in the case at hand, it failed to do so. Specifically, Congress needed to give the SEC guidance as to when the SEC can use its ALJ system and not merely give the SEC full discretion in deciding when to use the ALJ system.

The court explained how Congress constitutionally could not empower the SEC to decide which cases went to the ALJ process:

Through Dodd–Frank § 929P(a), Congress gave the SEC the power to bring securities fraud actions for monetary penalties within the agency instead of in an Article III court whenever the SEC in its unfettered discretion decides to do so. … Thus, it gave the SEC the ability to determine which subjects of its enforcement actions are entitled to Article III proceedings with a jury trial, and which are not. That was a delegation of legislative power.

Restrictions on the Removal of ALJs

Here, the court pointed out the fact that the President of the United States must have sufficient control over the performance of ALJs since they perform substantial executive functions. However, the court found that the President does not, in fact, have this power with the ALJs:

Simply put, if the President wanted an SEC ALJ to be removed, at least two layers of for-cause protection stand in the President’s way. Thus, SEC ALJs are sufficiently insulated from removal that the President cannot take care that the laws are faithfully executed. The statutory removal restrictions are unconstitutional.

The Fifth Circuit Court found that the procedure in existence at the time of the Jarksey litigation did not afford the President a sufficient amount of control. This issue of the President’s removal authority continues to be controversial and is the underlying issue in Cochran v. SEC. Perhaps unfortunately, the actual question before the Court in Cochran is not the underlying substantive issue. As this excellent piece by the law firm DLA notes, the issue in Cochran is whether a defendant can challenge the ALJ process on constitutional grounds before suffering through the ALJ trial and a finding of culpability on the part of the defendant.

Takeaways

At this moment, it remains unclear whether the SEC will be allowed to continue using the ALJ process. This lack of clarity does not mean that directors, officers, and companies should be any less vigilant when it comes to enforcing things like insider trading policies.

Remember: The SEC doesn’t have to get a conviction to make life miserable for directors and officers in a government investigation. The win isn’t arguing with the SEC for years only to have your conviction overturned. The win is never having the SEC knock at your door in the first place.

Having said that, there is no doubt that the outcome of the Supreme Court’s review in Jarkesy will be consequential for both the SEC and the potential subject of the SEC’s enforcement actions. For now, anyone being threatened with going before ALJ will want to think carefully about any constitutional defense they may have against being subject to the ALJ process.

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All views expressed in this article are the author’s own and do not necessarily represent the position of Woodruff-Sawyer & Co.

Priya Cherian Huskins

Senior Vice President, Management Liability

Editor, Management Liability/D&O

Priya is a recognized expert and frequent speaker on D&O liability risk and its mitigation. In addition to consulting on D&O insurance, she counsels clients on corporate governance matters, including ways to reduce their exposure to shareholder lawsuits and regulatory investigations. Priya serves on the board of an S&P 500 public company and a large private company and has an impressive list of publications, speaking engagements, and awards for her influence and expertise in the industry. 

415.402.6527

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Priya Cherian Huskins

Senior Vice President, Management Liability

Editor, Management Liability/D&O

Priya is a recognized expert and frequent speaker on D&O liability risk and its mitigation. In addition to consulting on D&O insurance, she counsels clients on corporate governance matters, including ways to reduce their exposure to shareholder lawsuits and regulatory investigations. Priya serves on the board of an S&P 500 public company and a large private company and has an impressive list of publications, speaking engagements, and awards for her influence and expertise in the industry. 

415.402.6527

LinkedIn