Home Hedge Funds Federal Appeals Court Rules Against SEC In-House Judges

Federal Appeals Court Rules Against SEC In-House Judges


A federal appeals court ruled this week that the Securities & Exchange Commission’s use of its in-house courts had violated a hedge fund manager’s constitutional right to a jury trial—a decision that may have wider implications for the regulator’s enforcement powers.

In 2013, the SEC had accused George R. Jarkesy and his Houston-based firm Patriot28 of defrauding investors in two hedge funds and steering bloated fees to a brokerage firm CEO who was also charged in the agency’s case. The funds raised $30 million from investors, according to the agency, which alleged that Jarkesydeceived investors about the value of their holdings.

Photo Illustration by Staff; Dreamstime (3)

When the SEC believes an individual has violated securities laws, it can seek remedies from a federal court or bring a case before one of its administrative law judges, who can recommend sanctions that include suspension of investment advisor registrations, censures, industry bans, and monetary penalties.

The SEC took the latter course in its case against Jarkesy. An administrative law judge concluded that Jarkesy and his firm had committed securities fraud, and the SEC later imposed a $300,000 civil penalty, and ordered Jarkesy and Patriot28 to disgorge nearly $685,000 in ill-gotten gains. The commission also barred Jarkesy from the securities industry.

On Thursday, the U.S. Court of Appeals for the Fifth Circuit ruled that the SEC’s use of its in-house courts for Jarkesy’s case violated his Seventh Amendment right to a jury trial. The split 2-1 decision also found that Congress unconstitutionally delegated legislative power to the SEC in violation of the Constitution.

The ruling vacated the SEC’s order and remanded the case for further proceedings. 

It’s not clear whether the SEC intends to appeal the decision to the Supreme Court. The agency did not respond to a request for immediate comment.

Jarkesy said in a statement that he was relieved to put an end to his legal saga. “I trusted the appeals process and am grateful that the court found the SEC administrative proceedings unconstitutional. The court has given me my life back,” he said.

Judges Jennifer Walker Elrod and Andrew S. Oldham were in the majority. Elrod and Oldham were appointed by Presidents George W. Bush and Donald Trump, respectively. 

They focused attention on the SEC’s attempt to seek monetary penalties against defendants via its in-house forums. The judges wrote that Jarkesy and his firm “had the right for a jury to adjudicate the facts underlying any potential fraud liability that justifies penalties.” 

Elrod and Oldham also said that Congress had, through the Dodd-Frank law, improperly empowered the SEC to decide whether to bring enforcement actions for monetary penalties before a court or an administrative law judge. 

Congress “effectively gave the SEC the power to decide which defendants should receive certain legal processes (those accompanying Article III proceedings) and which should not. Such a decision—to assign certain actions to agency adjudication—is a power that Congress uniquely possesses,” the ruling states.

Judge W. Eugene Davis, who was appointed to the federal judiciary by President Gerald Ford, dissented.

Davis wrote that his colleagues misread previous Supreme Court decisions, and “the majority applies what is essentially a rigid, categorical standard, not the functional analysis required by the Supreme Court’s precedents.” He found no constitutional violations with the SEC’s administrative proceedings.

S. Michael McColloch, one of Jarkesy’s lawyers, hailed the ruling as a “massive success for both Mr. Jarksey and the Constitution.”

“The administrative state has been running roughshod over constitutional rights

for decades,” McColloch said in a statement. “This decision will begin to rein in out-of-control agencies.” 

Though the ruling curtails the SEC’s ability to seek monetary penalties via its administrative law judges, the agency can still seek other relief, such as barring an individual from the securities industry.

“Most cases seek monetary penalties,” says Greg Baker, a former SEC official and partner at Patterson, Belknap, Webb & Tyler. “So I don’t know how useful it will be for the SEC to pursue actions where you can only get a bar.”

Lisa Braganca, a securities attorney and former SEC official, says the ruling may not have too big of an impact given that most enforcement cases are settled, and the SEC can still seek monetary and other penalties via the courts. 

“They still have the same remedies, they just have to go to a different place to get them,” says Braganca, who is based in Chicago.

The agency has also cut back on using its administrative law courts in recent years. And while the SEC has civil enforcement powers, federal authorities can still press criminal charges against individuals accused of securities fraud.

Kurt Wolfe, a securities attorney with law firm Quinn Emanuel Urquhart & Sullivan, says there are benefits to the SEC’s administrative law courts, and not just for the regulator. “Sometimes defendants would like to have the merits of their case heard in that forum. It is almost always faster and often cheaper [than the courts],” he says.

Wolfe says that the SEC could make its administrative law judges optional.

“I think it’s a viable solution and there are other agencies that use administrative law judges on a voluntary basis,” Wolfe says. “It’s worth considering the opt-in framework.”

Write to Andrew Welsch at andrew.welsch@barrons.com

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