SEC Loses in ALJ Case, DOL’s Latest Fiduciary Rule Put on Hold, and SEC Reconsiders AI and Custody Rule Proposals

Welcome to our July Regulatory Roundup, where we provide a quick look at the latest regulatory developments. In this edition, we discuss the implications of the Supreme Court’s decision in SEC v. Jarkesy that limits the Commission’s use of in-house judges, two Texas federal district court judges issued stays blocking the implementation DOL’s Retirement Security Act and PTE 2020-02, and the SEC’s latest schedule for issuing various final Advisers Act rules. Enjoy!

Supreme Court Strikes Down SEC’s Use of In-House Judges for Fraud Cases

The Supreme Court decided SEC v. Jarkesy, finding that when the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment of the U.S. Constitution entitles the defendant to a jury trial. The SEC brought the case against George Jarkesy, a hedge fund manager and radio talk show host. He was charged with fraud, and his case was heard by one of the SEC’s administrative law judges (ALJ), ordering his advisory firm to pay disgorgement and prejudgment interest of approximately $1 million and fines of $300,000 each. Jarkesy was barred from the securities industry. Jarkesy appealed, and the Fifth Circuit held that the SEC’s in-house adjudication of the anti-fraud case violated his Seventh Amendment right to a jury trial.

What does this mean?

When the Division of Enforcement completes an investigation and is authorized to go ahead with enforcement proceedings, the SEC has a choice. It can initiate a civil case in a federal district court or institute administrative proceedings before an ALJ. Since the passage of the Dodd-Frank Act in 2010, the SEC can seek civil penalties in administrative proceedings, including fines of up to $725,000 per violation. In an ALJ proceeding, the administrative law judge, employed by the SEC, determines the facts of the case and decides what evidence is admissible. In federal court, the defendant has the right to a jury trial and the protections of the federal rules of civil procedure and evidence.

Effect on Advisers

The Jarkesy case is one of many recent cases attacking the authority of the SEC’s administrative law judges. Recognizing this trend, the SEC has been moving its fraud cases to federal court since 2018.

Most of the time, cases brought by the Division of Enforcement against investment are settled. Firms decide it's cheaper and quicker to settle instead of trying their luck against an administrative judge employed by the Commission. For example, in the Jarkesy case, the SEC brought the original proceeding before one of its ALJs in 2013. The ALJ’s decision was handed down in 2014, but it was six years before the SEC reviewed that decision and released its final order in 2020, affirming the ALJ’s decision. Jarkesy had to wait for the SEC’s final decision before he could appeal the case to federal court. The Fifth Circuit vacated the SEC’s decision in May 2022. The SEC sought a review of the Fifth Circuit’s decision, and the Supreme Court agreed to hear the case. The Supreme Court’s decision was issued on June 27, 2024. Ultimately, George Jarkesy had to wait more than ten years and presumably spend thousands in legal fees to challenge the SEC’s ruling against him and his advisory firm.

The fallout from this case is that the SEC will now face the burden of federal litigation when bringing fraud cases, which may result in the Commission becoming more careful in deciding which cases to litigate. It may also give advisers more leverage in settlement negotiations.

DOL’s Retirement Security Rule Stayed by Two U.S. Federal District Courts in Texas

The DOL’s latest effort to enact the Retirement Security Rule was put on pause in July, with two federal courts in Texas issuing preliminary injunctions to stop its effectiveness nationwide. As discussed in our blog post, What Advisers Need to Know Now About Giving Rollover Advice after September 23, 2024, the DOL passed the new rule, along with amendments to two prohibited transaction exemptions, PTE 2020-02 and PTE 84-24, to impose fiduciary obligations on financial advisers who give advice to retirement investors. The final rule was scheduled to take effect on September 23, 2024.

Industry groups brought two cases challenging the Retirement Security Rule, one in federal court for the Eastern District of Texas, Federation of Americans for Consumer Choice Inc. v. DOL, and another in the Northern District of Texas, Am. Council of Life Insurers v. DOL. Two other industry groups, the Financial Services Institute (FSI) and the Securities Industry and Financial Markets Association (SIFMA), filed a brief to join this second lawsuit, supporting the insurance industry. They argued that “the Department has no enforcement authority with respect to IRAs, which are governed by Title II. It has no power to regulate IRAs directly, and no power to regulate firms or individuals for services they provide in connection with IRAs.”

Both Courts granted the stay based on a determination that the plaintiffs would likely win their cases on their merits. In the Eastern District, the Court stayed the effective date of the Retirement Security Act and amended PTE 84-24 “until further order of the court.” In the Northern District, the Court stayed the effective date of the Retirement Security Rule and PTE 2020-02 while the lawsuit and any appeals are being decided.

For investment advisers, these rulings mean that the Retirement Security Rule and amended PTE 2020-02 will not be effective on September 23. The DOL is likely to appeal these rulings, but it is anyone’s guess when a definitive outcome will be reached. However, given that advisers have fiduciary obligations under the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers, it is still prudent for firms to continue following the policies and procedures developed to comply with PTE 2020-02.

SEC’s Predictive Analytics and Safeguarding Rules on the Backburner with Outsourcing and Cybersecurity Risk Management Rules on October’s Agenda

The SEC’s Spring 2024 Current Agenda was released on July 5, 2024, providing advisers with a mix of good news and bad news. On the good news side, the SEC decided to repropose the rules that would require investment advisers (Advisers Act Rule 211(h)(2)-4) and broker-dealers (Exchange Act Rule 15(l)-2) to eliminate or neutralize conflicts of interest that arise from the use of predictive analytics, artificial intelligence, or other covered technologies. The financial industry harshly criticized the proposal, including calls for a full withdrawal of the rule. According to the agenda, these rules will be reproposed in October 2024.

Additionally, the agenda indicates that the SEC is considering reproposing the Safeguarding Advisory Client Assets Rule (Advisers Act Rule 223-1) in October 2024. The original proposal broadened the scope of the Advisers Act Custody Rule (Rule 206(4)-2), presumably to provide greater protection to investors by broadening the scope of assets and demanding more from custodians.

And now for the bad news. The SEC’s proposed rule on Outsourcing by Investment Advisers (Final Advisers Act Rule 206(4)-11) is scheduled to be finalized by October 2024. As discussed by the SEC in its press release, “[t]he proposed rule would require advisers to conduct due diligence prior to engaging a service provider to perform certain services or functions. It would further require advisers to periodically monitor the performance and reassess the retention of the service provider in accordance with due diligence requirements to reasonably determine that it is appropriate to continue to outsource those services or functions to that service provider.”

And in more bad news, the SEC also intends to issue its final rules on Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies, and Business Development Companies. (Advisers Act Rule 206(4)-9). These rules will require investment advisers and investment companies to “adopt and implement written cybersecurity policies and procedures reasonably designed to address cybersecurity risks, disclose information about cybersecurity risks and incidents, report information confidentially to the Commission about certain cybersecurity incidents, and maintain related records,” according to the SEC’s press release. The agenda indicates these new rules will be finalized by October 2024.

Photo by Miikka Luotio on Unsplash