Supreme Court to give SEC in-house judges day in court

Judge not, lest ye be judged, warns The Bible. 

A case going before the U.S. Supreme Court is putting a new spin on that admonition with questions over the SEC's use of in-house judges to oversee charges it brings in securities cases. 

The U.S. Supreme Court on Friday decided to take up Jarkesy v. the Securities and Exchange Commission, which questions the Wall Street's regulator's authority to bring cases alleging securities and fiduciary violations before internal tribunals. The petitioner in the case, George Jarkesy, was ordered in 2013 to appear before one of the SEC's in-house judges over charges that he and his advisory firm, Patriot28, had mismanaged a pair of hedge funds overseeing $24 million in assets.

The internal judge presiding over his case found he had violated securities laws, and the SEC later ordered him to pay almost $1 million. Jarkesy sought to have the decision overturned on appeal and eventually prevailed on arguments that the SEC had exceeded its constitutional authority with its use of in-house judges, also known as administrative law judges.

The U.S. Supreme Court will now be taking up the SEC's bid to have the appellate court's ruling reversed. In seeking to have the appeals decision overturned, SEC lawyers argued the case presents questions of "exceptional importance."

The appellate decision "nullifies provisions Congress determined necessary to enforce the securities laws and calls into question adjudication within the Executive Branch more broadly.

The SEC's use of administrative law judges is a subject of longstanding controversy. Critics contended the system doesn't provide enough distance between the officials who bring cases against advisors and other financial professionals and the officials who often rule on those cases.

Read more: The big bucks mutual fund firms kick back to wealth managers

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.

In the Jarkesy case, the Fifth Circuit Court of Appeals found several grounds for questioning the constitutionality of the SEC's in-house judges. In a 2-1 decision in May 2022, the appellate judges found that Congress had violated the Seventh Amendment's guarantee of jury trials in civil cases by allowing ALJ's to impose civil penalties. 

The court also found that Congress had afforded the SEC too much discretion over which cases go before its in-house judges and which can proceed in the regular court system.

FInally, the judges ruled that the SEC's reliance on an internally selected board to remove ALJ's from office unconstitutionally shielded them from direct removal by the U.S. president.

The SEC has greatly decreased its reliance on ALJs in recent years. And in June the regulator announced it was dismissing more than 40 cases scheduled to go before its administrative law judges after finding that internal memoranda had been mishandled by its staff.

In asking the Supreme Court to reconsider the appellate court's decision, the SEC argued that case law shows numerous instances in which federal agencies have been allowed to impose civil fines outside the regular court system. That's especially true, the SEC argued, in cases involving specialized matters like security law.

"Congress may constitutionally authorize federal agencies to impose civil monetary penalties for violations of federal law regarding "commerce, taxation, immigration, public lands, public health," and other areas," according to the SEC's brief.

Read more: Do you know your mutual fund manager's birthday? It might be costing you

Deborah Meshulam, a partner in law firm DLA Piper's Washington, D.C., office and a former chief litigation counsel in the SEC's enforcement division, said the practical effects of the Supreme Court's coming decision will largely depend on how much of the appellate court's ruling the justices agree with. Even if the high court does eventually find the SEC's ALJ system to be unconstitutional, it doesn't necessarily have to accept the appeals decision in its entirety.

Regardless of the outcome, Meshulam said, the SEC will retain its broad enforcement powers. The only real question is about the forum in which its cases should be heard.

"For example, if they merely ruled there was a right to a jury trial in certain types of cases, with civil penalty cases, then that by itself could mean the SEC would probably be more inclined to bring those cases in federal court," she said.

Peggy Little, a senior litigation counsel at the New Civil Liberties Alliance who has represented clients in several cases challenging in-house judges, said she hopes the Supreme Court decisively rejects the SEC's current use of ALJs.

"It needs to address the issue of having people judged before an agency that is also charging them, which means the prosecutor reports to the same boss as the same judge," Little said. "That's an inherent structural problem."