Supreme Court’s restriction of SEC enforcement actions is a win for D&O policyholders, but questions remain

For more than 30 years, the Securities and Exchange Commission (SEC) has pursued enforcement actions against regulated entities via both federal courts and in-house administrative proceedings. A recent Supreme Court ruling, however, puts significant limits on what actions the SEC can bring outside the courtroom. This could have significant implications — both positive and negative — for directors and officers liability (D&O) insurance buyers.

The SEC and administrative proceedings

Originally, SEC enforcement actions could only be initiated in federal district court, a forum in which the right to a jury trial is guaranteed by the Seventh Amendment to the U.S. Constitution. In 1990, however, Congress passed the Securities Enforcement Remedies and Penny Stock Reform Act, which allowed the SEC to pursue enforcement actions against entities it regulated in administrative proceedings before administrative law judges (ALJs).

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act expanded the SEC’s ability to bring enforcement actions in administrative proceedings against nonregulated entities as well. The SEC may still choose to pursue enforcement actions in courts, but typically, enforcement actions are brought as administrative proceedings, where the SEC effectively acts as prosecution, judge, and jury.

The plaintiff in the case at hand, George Jarkesy, was a hedge fund manager whom the SEC began investigating in 2011. The SEC later commenced in-house administrative proceedings seeking civil penalties for securities fraud against Jarkesy and Patriot28, LLC, an investment advisor. The ALJ overseeing the proceedings determined that Jarkesy and Patriot28 committed securities fraud and ordered the defendants to pay a civil penalty of $300,000 and disgorge approximately $685,000 of profits.

The defendants petitioned the 5th Circuit Court of Appeals to enjoin the agency proceedings against them, arguing that the in-house administrative proceedings deprived them of various constitutional rights. The appellate court agreed, holding that the administrative proceedings wrongfully deprived the defendants of their right to a trial by jury.

The ruling

In a 6-3 decision in SEC v. Jarkesy, issued on June 27, the U.S. Supreme Court agreed with the 5th Circuit’s ruling (opens a new window), holding that SEC enforcement actions seeking civil penalties for fraud must be brought in federal district court, and defendants in those proceedings must be afforded the right to a trial by jury. The majority rejected the dissent’s argument that SEC enforcement actions involved the adjudication of so-called “public rights,” proceedings which may properly be venued in administrative tribunals.

The majority was careful to emphasize that only those enforcement actions involving “private rights” must be adjudicated in federal district court. This means the SEC may still be able to execute some types of enforcement actions in administrative proceedings. The Jarkesy ruling, however, makes clear that any SEC enforcement actions involving fraud must be commenced in federal district court, and the defendants must be afforded the right to a trial by jury.

Implications for D&O coverage

The implications of the Jarkesy decision for D&O policyholders and carriers could be significant. On the one hand, if SEC enforcement actions must be brought in federal district court, defendants in those proceedings would gain the benefit of a right to trial by jury, instead of a trial by a SEC ALJ. This would likely mean it will be more difficult for the SEC to prevail in enforcement actions, with a concomitant lower risk of exposure for D&O carriers. The SEC may also be more circumspect about initiating enforcement actions, opting to focus its efforts on those cases it is most likely to win.

Costs for companies facing enforcement actions, however, could increase. Defense costs for cases filed in federal district court will likely be greater than the costs to defend cases pursued as in-house administrative proceedings, due to the added complexity of federal district court practices.

Consulting with insurance and legal advisors

D&O insurance typically provides coverage to corporations and their directors and officers for alleged violations of securities laws and regulations, including those enforced by the SEC. As Jarkesy could result in the SEC focusing its efforts on enforcement proceedings it is more likely to win, it could curtail the agency’s aggressiveness in connection with environmental, social, and governance (ESG), cybersecurity, and other related matters.

This would, in turn, result in reduced exposure for D&O carriers. But it also could inflate costs for insureds, given how expensive it can be for businesses to defend litigation in federal courts.

The Jarkesy decision could also limit — or at least bring into question — the ability of other federal regulators to pursue enforcement proceedings in-house. Other agencies that make use of ALJs include the Environmental Protection Agency, Federal Communications Commission, Federal Trade Commission, National Labor Relations Board, and Occupational Safety and Health Administration.

Jarkesy is seen as generally favorable to the D&O market and to public companies regulated by the SEC. Nevertheless, insurance buyers may wish to work with their insurance brokers to review their D&O policies to ensure they have sufficient limits and coverage in place to manage potentially greater defense costs. Policyholders should also consult with their insurance brokers and insurance counsel to understand the broader impacts of Jarkesy, including potential implications for other lines of coverage.