Case questions SEC right to haul advisors before in-house judges

If the U.S. Supreme Court rules against the SEC in a case involving a hedge fund manager accused of fraud, advisors may never have to worry about going before the agency's in-house tribunals again.

Appearing before the court Wednesday, attorney Michael McColloch argued that most of the complicated legal questions presented in the fraud case SEC v. Jarkesy could be unraveled simply by allowing advisors and other financial professionals who find themselves accused of misdeeds to choose which forum they want to defend themselves in. The problem, McColloch said, is that the Securities and Exchange Commission can now bypass regular courts by forcing these disputes before its in-house administrative law judges, also known as ALJs.

"It's coercive," McColloch said. "The SEC gets to unilaterally strip your Seventh Amendment right to a jury and other rights away. The SEC could fix this right now."

McColloch, who runs a law firm under his own name in Dallas, appeared before the Supreme Court on Wednesday to argue on behalf of George Jarkesy, a former advisor and hedge manager who was accused by the SEC in 2013 of making misstatements about a pair of funds holding $24 million in client assets. Seven years later, an SEC in-house judge found Jarkesy had violated various securities laws and ordered him and his advisory firm, Patriot28, to pay $300,000 in civil penalties and disgorge $686,000 in allegedly ill-gotten gains.

Jarkesy, now the host of a conservative radio talk show, had meanwhile been conducting his own legal campaign in federal courts questioning the SEC's basic right to hear cases like his in house. He succeeded in May 2022 before the Fifth Circuit Court of Appeals, which overturned the SEC's decision to impose civil penalties.

The Wall Street regulator has long had the power to bar firms or individual advisors from the industry. But only with the adoption of the Dodd-Frank Act in 2010 — passed in response to the financial collapse two years earlier — did its administrative law judges gain broad powers to impose civil penalties.

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Jarkesy's case questions this authority on several grounds. Most significantly to the justices on Wednesday, it argues that the SEC's in-house judges' ability to impose civil penalties violates defendants' Seventh Amendment right to have federal civil cases heard before juries.

Arguments with a lot on the line
The stakes are high. The SEC oversees more than 14,800 investment advisors who collectively manage roughly $128 trillion in assets for institutional and retail clients. In its latest fiscal year, the agency brought in nearly $5 billion in enforcement penalties against numerous financial institutions and professionals. 

McColloch and the Supreme Court justices made it clear that the questions surrounding the right to a jury trial were of the highest concern on Wednesday. McColloch said many of the misdeeds Jarkesy stands accused of are at least "analogous" to common law understandings of fraud. 

With such common law cases, he said, the standard procedure is to have them heard in a regular court. Nothing in the Dodd-Frank Act or other securities legislation adopted by Congress gives the SEC the right to diverge from that basic practice, McColloch argued.

Accusing the SEC of overreach, McColloch likened it to a "house that's been added onto too many times and it's crushing the foundation."

Speaking in the SEC's defense on Wednesday. Brian Fletcher, principal deputy solicitor general in the Department of Justice, contended that courts have long upheld Congress's ability to delegate certain adjudicatory powers to administrative agencies. In what he deemed the most prominent test of these congressional powers, he cited the 1977 case of Atlas Roofing v. the Occupational Safety and Health Administration.

The Supreme Court then decided that OSHA in-house judges charged with enforcing workplace safety standards were within their rights to impose civil penalties on two construction companies following worker deaths at their sites. But it's not just OSHA whose enforcement powers rely heavily on in-house judges, Fletcher argued.

Administrative law judges now hand down many of the decisions in cases touching on everything from taxes and Social Security to immigration and customs enforcement. He warned that a decision against the SEC in the Jarkesy case could have consequences that reach far beyond what anyone intends. The court, he said, could in effect be undoing administrative practices that have been in place for more than a century.

"I think that's a heavy task for the court to take on," Fletcher said. "And, I think, if you're inclined to do it, you certainly shouldn't do it in a case like this one."

'Asymmetrical' proceedings
Jarkesy's case against the SEC comes amid a general erosion of the powers of the administrative state following former President Donald Trump's appointment of three conservative justices to the high court. In May, for instance, the Supreme Court handed down a decision rolling back the Environmental Protection Agency's authority to enforce regulatory protections for wetlands.

A separate case involving an investment advisor went before the Supreme Court in November 2022 over questions of whether plaintiffs should be able to turn to federal courts to challenge ALJ's constitutionality. That dispute was dismissed in June when the SEC dropped 42 pending enforcement cases after discovering its staff had mishandled internal memos.

Critics of the SEC have long contended its in-house judges are too close to the regulators who bring allegations against advisors and other financial professionals. By housing both its adjudication and enforcement functions essentially under the same roof, many argue, the SEC gains a formidable "home-court advantage."

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Indeed, a 2015 analysis of SEC data by The Wall Street Journal found that the SEC rarely loses before its own administrative law judges. The regulator prevailed in 90% of the cases it brought before in-house ALJs from October 2010 to March 2015. By contrast, the newspaper found, the SEC won only 69% of the cases taken before federal courts in the same period.

McColloch said Wednesday that he has few doubts about whether advisors and other financial professionals would pick in-house tribunals over regular courts if given a choice. He noted defendants' ability to obtain discovery — preview evidence before it's formally presented — is severely restricted in SEC administrative proceedings. He also said the SEC will often take much longer, sometimes years, to prepare a case that's going to be argued in house.

Peggy Little, a senior litigation counsel at the New Civil Liberties Alliance who has represented clients in several cases challenging in-house judges, agreed during a webinar held by the conservative Federalist Society that proceedings before SEC in-house tribunals are "asymmetrical."

"In administrative proceedings, you are often rushed when the SEC has had years to prepare against you," Little said. "You are given a document drop and asked to prepare in weeks and then you have to wait forever and ever for a decision."

Little said it was difficult to get a read from Wednesday's oral arguments on how the Supreme Court will eventually come down in the Jarkesy case. She guessed that the majority of the justices will seek to curtail the powers of the SEC in some ways but stop short of overturning court precedents or making far-reaching changes to other agencies' authority.

The conservatives on the court did seem to express skepticism about the SEC's powers. Justice Brett Kavanaugh, nominated by Trump in 2018, said that it "seems problematic to say the government can deprive you of your property, your money, substantial sums in a tribunal that is at least perceived as not being impartial."

Amid the heightened scrutiny of ALJs, the SEC has largely backed off taking cases through its internal adjudication system. Fletcher said the SEC now has only three in-house judges on staff. He also noted that anyone found in violation by an in-house tribunal and other federal agencies has always had the right to appeal in court.

"I think that's something that Congress has long done as provided for administrative adjudications first and judicial review later," he said. "That's obviously subject to due process constraints. But when it is consistent with those constraints — and there's no challenge here that this scheme is not — then it is consistent with our tradition."