There’s No Place Like Home: The Constitutionality of the SEC’s In-House Courts

Until recently, it was extremely rare for the SEC to bring enforcement actions against unregulated entities or persons in its administrative court rather than in federal court. However, as a result of the Dodd-Frank Act (and perhaps the SEC’s lackluster record in federal court trials over the past few years), the SEC is committed to bringing, and has in fact brought, more administrative proceedings against individuals that previously would be filed in federal court. Many have questioned the constitutionality of these administrative proceedings. As U.S. District Judge Jed Rakoff remarked in August 2014: “[o]ne might wonder: From where does the constitutional warrant for such unchecked and unbalanced administrative power derive?” Several recent SEC targets agree with Judge Rakoff, and have filed federal court suits challenging the constitutionality of the SEC’s administrative proceedings. (Notably, in a 2011 order regarding the SEC’s first attempt to use its expanded Dodd-Frank powers to bring more administrative cases, Judge Rakoff denied a motion to dismiss a constitutional challenge to the SEC’s decision to bring an administrative proceeding in an insider trading case against an unregulated person, following which the SEC terminated that proceeding and litigated in federal court.)

Earlier this year, challenges to SEC administrative proceedings were brought in Chau v. SEC and Jarkesy v. SEC. The Chau case, which raised due process and equal protection concerns, is still pending before Judge Kaplan in the U.S. District Court for the Southern District of New York. In Jarkesy, the D.C. District Court dismissed the action, in which the plaintiffs argued, in part, that the SEC’s decision to initiate administrative proceedings against them violated their right to equal protection. The district court did not address the substance of Mr. Jarkesy’s constitutional challenge, instead ruling that the matter was not ripe for federal court consideration at least until after the SEC administrative law judge (“ALJ”) has an opportunity to consider Mr. Jarkesy’s defenses. An appeal to the D.C. Circuit is pending.

More recently, on September 30, 2014, the SEC issued an Order Instituting Cease-and-Desist Proceedings (“OIP”) against Jordan Peixoto, alleging insider trading in connection with the securities of Herbalife, Ltd. The OIP sets Mr. Peixoto’s case not in federal district court, as is typically the case with insider trading charges against unregulated persons, but in front of an SEC ALJ. Mr. Piexoto responded by bringing suit against the SEC on October 20, 2014. Mr. Peixoto’s complaint, filed in the Southern District of New York, argues that the proceeding is unconstitutional under Article II of the U.S. Constitution and violates his rights to equal protection and due process. Mr. Peixoto’s arguments are virtually identical to those made in Joseph Stilwell’s complaint against the SEC filed on October 1, 2014. Mr. Stilwell, an investment advisor registered with the SEC, filed a case seeking declaratory and injunctive relief because he claimed to face an imminent SEC administrative proceeding on his alleged fraud.

The crux of the recent Piexoto and Stilwell complaints is that it is difficult for the President to remove ALJs, who are executive branch officers, from their positions and that this violates Article II of the U.S. Constitution.Citing a Supreme Court decision from a few years ago that held that the Public Company Accounting Oversight Board was unconstitutional to the extent it prohibited the President from terminating Board members except “for cause,” the complaints argue that because the President cannot oversee SEC ALJs in accordance with Article II, the SEC administrative proceedings in question are unconstitutional. In addition, Mr. Peixoto has argued that he is at a considerable disadvantage before an ALJ, given that numerous procedural safeguards available in federal district court, including the absence of a jury and potential admissibility of multiple layers of hearsay evidence that the SEC will seek to offer, do not apply in the administrative forum.

The Stilwell and Peixoto complaints represent widely-shared skepticism about the constitutionality of the SEC’s administrative proceedings and, pending resolution of the issue by the appellate courts or the Supreme Court itself, the SEC may now find itself routinely having to justify the constitutionality of its in-house courts before district court judges.