May 20, 2022

Fifth Circuit Rules SEC Administrative Adjudications Unconstitutional

In a 2-1 ruling, a panel of the U.S. Court of Appeals for the Fifth Circuit held that SEC administrative proceedings as currently implemented are unconstitutional.

The case arose from an SEC enforcement action brought against the manager of two hedge funds and the funds' unregistered investment adviser (collectively, the "Petitioners") before an SEC administrative law judge ("ALJ") (see related coverage). The SEC had charged that the Petitioners (i) "misrepresented who served as the prime broker and as the auditor"; (ii) "misrepresented the funds' investment parameters and safeguards"; and (iii) "overvalued the funds' assets to increase the feeds that they could charge investors."

After the ALJ concluded that the Petitioners engaged in securities fraud, the Petitioners appealed to the SEC for review. The SEC affirmed the ALJ's ruling that the Petitioners committed various acts of securities fraud, and ordered the Petitioners to "cease and desist from committing further violations and to pay a civil penalty of $300,000" and ordered the investment adviser to "disgorge nearly $685,000 in ill-gotten gains." Additionally, the SEC barred the hedge fund manager from certain securities industry activities (e.g., associating with brokers, dealers, and advisers; serving as officer or director of an investment adviser, etc.). In response to the SEC's ruling, the Petitioners appealed the SEC's determination and filed a petition for the Fifth Circuit's review of the SEC's in-house adjudication of the matter.

The Fifth Circuit ruled that the SEC's in-house adjudication of the enforcement action involving alleged violations of various antifraud provisions of the Securities Act, the Exchange Act, and the Advisers Act by the Petitioners was unconstitutional because:

  • the SEC's in-house adjudication of the specific claims involved in the case violated the Petitioners' right to a jury trial under the Seventh Amendment of the Constitution;
  • 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 statutory removal restrictions applicable to SEC ALJs violate the "Take Care" clause of Article II of the Constitution.

The Fifth Circuit vacated the SEC's previous adjudication that the Petitioners' violated the antifraud provisions of various securities laws.