Tracking the Fifth Circuit: A Focus on Administrative Law Judges

By Hon. Patricia M. French

A series of matters were brought before the Fifth Circuit U.S. Court of Appeals, that resulted in holdings questioning inter alia the constitutionality of certain adjudicatory proceedings before federal administrative agencies, as well as the manner by which administrative law judges (ALJs) appointed at the nation’s federal agencies may be removed from their positions.

Patricia M. French practiced energy and utility law in the public and private sectors for over 30 years before being appointed an administrative law judge for the United States, following competitive examination. Her current tour is with the Federal Energy Regulatory Commission. She is also an officer of the Federal Administrative Law Judges Conference. Any opinions stated are hers, and hers alone.

This article1 reflects the path of one of those matters that has landed now as a petition for review pending before the U.S. Supreme Court.2

This matter began a decade ago, in 2013, with an Order Instituting Proceedings (OIP) duly issued by the Securities and Exchange Commission (SEC or Commission) pursuant to § 8A of the Securities Act of 1933,3 §§ 15(b)(4), 15(b)(6) and 21C of the Securities Exchange Act of 1934,4 §§ 203(e), 203(f), and 203(k) of the Investment Advisers Act of 1940,5 and § 9(b) of the Investment Company Act of 1940.6 The respondents then sued the Commission in the U.S. District Court for the District of Columbia, seeing to enjoin agency action on constitutional grounds. The district court dismissed the suit for lack of jurisdiction and was upheld on appeal to the U.S. Court of Appeals for the District of Columbia Circuit.7 In the meantime, the matter was assigned to a Commission ALJ who held in-person and remote administrative hearings during several weeks in 2014. Before the ALJ were the OIP allegations that the respondents’ dealings with certain hedge funds resulted in material misrepresentations and omissions in violation of federal law, and that those misrepresentations and omissions regarding those funds, their placement agent, and their owner, fell within the SEC’s jurisdiction to oversee in the public interest. The respondents were represented by private counsel; the public interest was represented by the SEC internal trial counsel from the SEC’s Division of Enforcement (Division).

The ALJ’s initial decision (ID) in the administrative proceeding8 addresses the threshold arguments of:

(1) alleged due process and equal protection violations, as well as deprivation of equal protection; (2) alleged violations of Brady requirements;9 and (3) the time-barred nature of the OIP claims. The ID then makes lengthy and specific findings of fact based upon the evidence presented at the evidentiary hearing and weighs the record in light of the testimonial inconsistencies of one respondent. It relies on hearing evidence to specify material misrepresentations and omissions of this respondent or entities under respondent’s control. The ID then evaluates the various securities acts (§ 17(a) of the Securities Act,10 § 10(b) of the Exchange Act,11 and §§ 206(1), 206(2) and 206(4) of the Advisors Act)12 that prohibit aiding the willful violation of the relevant antifraud provisions, in order to protect investors and the public interest. The ID’s findings of fact include that the respondents were deemed fiduciaries, investment advisors and/or associated persons of an investment advisor, all within the meaning of the relevant statutes. The ID determines the respondents aided and abetted the violations of the securities laws, and did so willfully, and in doing so violated the applicable law.

As allowed by statute, the respondents sought independent review in first appealing the ID to the Commission resulting in an opinion issued in 2020,13 which delay in issuance was caused by the issuance of the Lucia decision14 after which the respondents waived their right to a new hearing. In its 2020 opinion, the Commission determined that the respondents violated the relevant acts, and imposed a bar on one of the respondents and a cease-and-desist on the others. The Commission further mandated civil penalties to be borne jointly and severally and requires disgorgement of monetary gains obtained in contravention to law. The Commission recited with specificity the facts it found persuasive in determining that the respondents violated the Exchange Act § 10(b) and Rule 10b-5(b),15 Securities Act § 17(a)(2),16 and Advisors Act § 206(4) and Rule 206(4)-8.17 The Commission confirms in its opinion that the evidence adduced at hearing supports the finding that the respondents violated the antifraud provisions of these statutes by knowingly or recklessly making material misstatements or omissions in its funds marketing, including materially misrepresenting the identities of the auditor and prime broker, even after being asked by the prime broker to remove its name; materially misrepresenting the asset allocation and investment strategy, which is an important consideration to a reasonable investor; lacking justifications for its material misrepresentations to investors (“not every mixture with true will neutralize the deceptive”); and blaming others for its material misrepresentations, including its former counsel. The Commission confirmed the substantial evidence supported finding the respondents knowingly or recklessly made material misstatements and omissions about asset valuations, including misrepresenting the value of the relevant assets in financial statements and monthly statements of account by failing to write down defaulted notes, unreasonably inflating valuations of stocks and warrants that had no traded value (and then changing those valuation assumptions), and overvaluing other investments in penny stocks with no quoted price that the Commission indicated was regarded by the respondents themselves as “essentially worthless,” and in restricted stock.

Finally, in its opinion, the Commission also found the respondents materially overvalued life settlement policies in their reports and records. All of the misrepresentations are deemed to be material and made with scienter. The Commission opinion specifically identified the statutes that authorize it to bar a person from association with an investment company or from the offering of penny stock, if the Commission finds that the person is in willful violation of federal securities laws and that the bar is in the public interest (Investment Company Act § 9(b), 15 U.S.C. § 80a-9(b), 15 U.S.C. § 80b-3(f)); Exchange Act § 15(b)(6)), 15 U.S.C. § 78o(b)(6)). The Commission opinion concluded that respondent Jarkesy poses a significant danger to investors, which is within the scope of the public interest that the Commission is required to protect, and that barring respondent Jarkesy from the securities industry (including from participating in a penny stock offering) is also in the public interest. The Commission opinion also imposed a cease-and-desist order with monetary penalties against the respondents as a result of the fraudulent misconduct of the nation’s securities laws, all as permitted by statute (Securities Act § 8A, 15 U.S.C. § 77h-1(g)(1); Exchange Act § 21B, 15 U.S.C. § 78u-2; Advisers Act § 203(i), 15 U.S.C. § 80a-9(d); Investment Company Act § 9(d); 15 U.S.C. § 80b-3(i)). Disgorgement is also mandated for one of the respondents (Securities Act § 8A(e), 15 U.S.C. § 78u-2; Exchange Act §§ 21B(e) and 21C(e), 15 U.S.C. §§ Advisers Act § 203, and Investment Company Act § 9(e)).

After its independent review of the substantial evidence and the law, the Commission addressed fully the respondents’ constitutional and procedural claims, dismissing each. As supported by ample precedent, and consistent with constitutional principles, administrative law judges are charged under the Administrative Procedures Act with developing an evidentiary record and making recommendations regarding the application of law, and the SEC itself independently reviews those “initial” decisions in the public interest, a charge given to no other entity in the federal scheme, resulting in its own opinion, and with the full opportunity for errors of the Commission’s opinion to be reviewed by Article III courts.

The respondents appealed. The Fifth Circuit majority, on appeal, vacated the decision and remanded to the Commission. 18 Contrary to the holdings of the DC Circuit earlier, the Fifth Circuit majority determined the SEC’s in-house adjudication of the matter violated the respondent’s (now petitioners’) Seventh Amendment right to a jury trial. It found that Congress unconstitutionally delegated legislative power to the SEC by failing to provide an “intelligible principle” by which the SEC would exercise the delegated power, in violation of Article I of the Constitution, and the matter was therefore not “properly assigned.” And finally, it determined that the statutory removal restrictions on the Commission’s administrative law judges violates the “take care clause” of Article II of the Constitution. The Fifth Circuit majority declared unconstitutional the lengthy agency proceedings designed by Congress to protect the broader public interest of the nation’s investors and which ensure the broader public’s confidence and trust in the regulated financial advisor and investment communities.

The Fifth Circuit’s majority opinion relied tightly on the view that agency proceedings are only undertaken to remedy a “public right” and that the private rights vindicated here were inappropriately delegated by Congress; that the rights “vindicated” by the SEC are grounded in “common law fraud,” which, under the Seventh Amendment, is within the province of the courts; and that actions seeking “civil penalties” are a type of remedy it says are only “enforced” in a court of law. The Fifth Circuit majority confirmed its interpretation that the right being vindicated in this matter is a private right, not a public one, and that once more, actions to enforce a private right must be heard by an Article III court with the constitutional right to a jury trial. The dissenting opinion argued the rights being adjudicated at the SEC are clearly and properly delegated public rights and that a vast history of Supreme Court precedent upholds that position; that because the enforcement action is vindicating a public right, the Seventh Amendment does not prohibit adjudication by a jury-less administrative forum, and Congress properly and constitutionally delegated power to the executive branch to make the forum choice for the underlying SEC enforcement action; and finally, that ALJs perform adjudicative functions resulting in recommendations (subject to agency review) and are not central to the functioning of the executive branch for the purposes of Article II removal protections.

The Fifth Circuit denied the SEC’s request for an en banc rehearing.19

In this entirety of context, the SEC framed the following issues on its request for certiorari: (1) whether statutory provisions that empower the SEC to initiate administrative enforcement proceedings seeking civil penalties violate the Seventh Amendment; (2) whether statutory provisions that authorize the SEC to choose to enforce the securities laws through agency adjudication instead of filing a district court action violate the nondelegation doctrine; and (3) whether Congress violated Article II by granting for-cause removal protection to administrative law judges whose heads enjoy for-cause removal protection. The SEC argued that the Fifth Circuit majority opinion facially invalidated the provisions of the Securities Act, Exchange Act, and Advisers Act that empower the Commission to bring administrative proceedings seeking civil penalties and disgorgement. The Court further held the provision originally in the Administrative Procedures Act that makes ALJs removable only for cause20 is invalid as applied to SEC ALJs. The SEC argued that the Fifth Circuit majority opinion conflicts with other decisions of the U.S. Supreme Court, is in contrast to Congress’ clear intent making ALJs removable only for cause over 80 years ago,21 and “casts a cloud” on federal statutes that are relied upon by agencies conducting adjudications in the public trust.22

Endnotes

1With immense thanks to my clerk, Sigifredo Perez, for his careful review and editing of this piece on his own time.

2Petition for Writ of Certiorari, Sec. & Exch. Comm’n, v. Jarkesy, No.

22-859 (filed Mar. 9, 2023).

315 U.S.C. § 77h-1.

4See 15 U.S.C. §§ 78o(b)(4), (6); 15 U.S.C. § 78u-3.

5See 15 U.S.C. §§ 80b-3(e), (f), (k).

6See 15 U.S.C. § 80a-9(b).

7Jarkesy v. United States Sec. & Exch. Comm’n, 48 F. Supp. 3d 32 (D.D.C. 2014), aff’d sub nom. Jarkesy v. S.E.C., 803 F.3d 9 (D.C. Cir. 2015).

8John Thomas Capital Mgmt. Grp. LLC, d/b/a Patriot28 LLC, Initial Decision Release No. 693, 2014 WL 5304908 (Oct. 17, 2014).

9Brady v. Maryland, 373 U.S. 83, 87 (1963) (regarding the Division’s responsibility to make investigatory files and material exculpatory evidence available to the respondent).

10See 15 U.S.C. § 77q(a).

1115 U.S.C. § 78j(b).

1215 U.S.C. §§ 80b-6(1), (2), (4).

13See, In the Matter of John Thomas Cap. Mgmt. Grp. LLC, d/b/a Patriot28 LLC & George R. Jarkesy, Jr., Release No. 5572 (Sept. 4, 2020).

14Lucia v. S.E.C., 138 S. Ct. 2044 (2018).

1515 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5(b).

1615 U.S.C. § 77q(a)(2).

1715 U.S.C. § 80b-6(4); 17 C.F.R. § 275.206(4)-8.

18Jarkesy v. Sec. & Exch. Comm’n, 34 F.4th 446, 465-66 (5th Cir. 2022).

19Jarkesy v. Sec. & Exch. Comm’n, 51 F.4th 644 (5th Cir. 2022).

205 U.S.C. § 7521(a).

21Administrative Procedure Act, Pub.L. No. 79–404, § 11, 60 Stat. 237, 244 (1946).

22Petition for Writ of Certiorari, Sec. & Exch. Comm’n, v. Jarkesy, No. 22-859 (filed Mar. 9, 2023).