Supreme Court decision could see SEC facing logjams in enforcement cases

A recent U.S. Supreme Court decision could have major implications for Securities and Exchange Commission enforcement, but there are larger legal questions looming that need to be settled before anything is certain, attorney sources said.

The Supreme Court's unanimous decision on April 14 granting companies and people facing SEC charges the ability to challenge the agency's constitutional authority in U.S. District Court before the SEC resolves the matter in-house could cause "headaches" for at least some of the SEC's enforcement efforts, said Christian D. H. Schultz, a Washington-based partner at Arnold & Porter Kaye Scholer LLP and former assistant chief litigation counsel in the SEC's enforcement division.

"There will be many cases that the commission may want to bring in an administrative proceeding where the defendant could say, 'Well I should have this heard by a jury, not some in-house judge,' which creates a constitutional issue for a federal court to resolve and that jams up the SEC from doing anything in that administrative proceeding," Mr. Schultz said.

"The whole administrative proceeding process really has the potential to get jammed up significantly."

The case in question, SEC vs. Cochran, which was combined with a similar case, Axon Enterprise Inc. vs. FTC, focuses on a procedural issue involving the SEC's use of administrative law judges, or ALJs, which handle administrative enforcement cases in-house.

The plaintiff, Michelle Cochran, an accountant facing SEC administrative charges of violating federal accounting standards, originally challenged the constitutionality of the SEC's ALJ system in the Northern District of Texas in 2019. She asked the court to allow her to challenge the constitutionality of the ALJs in a U.S. District Court before the conclusion of the agency adjudication. Historically, a person or company facing charges heard before an ALJ has to go through a lengthy administrative process before bringing a case to challenge the constitutionality.

After losing the initial case, Ms. Cochran appealed to the Fifth U.S. Circuit Court of Appeals in New Orleans and lost once more. She then petitioned the Fifth Circuit for an en banc hearing before all judges of the court and the full court in December 2021 reversed the initial decision.

The Supreme Court heard oral arguments in Ms. Cochran's case and the Axon case in November and seemed open to siding with the plaintiffs.

But the court's unanimous decision was still surprising to sources. "A 9-0 (decision) means you can't get a, 'You're more wrong' opinion from the Supreme Court," Mr. Schultz said.

In the court opinion written by Justice Elena Kagan, the court found that the "statutory review schemes set out in the Securities Exchange Act and Federal Trade Commission Act do not displace a district court's federal-question jurisdiction over claims challenging as unconstitutional the structure or existence of the SEC or FTC."

The New Civil Liberties Alliance and law firm Latham & Watkins LLP, which represented Ms. Cochran in the case, said in a statement that for decades, "Americans have been hauled before agencies which act as investigator, prosecutor, judge and their first court of appeal. Whether that is constitutional is, as Justice Kagan notes at the outset, 'fundamental, even existential.'"

When asked for comment on the Cochran decision, an SEC spokesman said in an email that "we're reviewing the opinion of the court."

Following a 2018 decision in another case, Lucia vs. SEC, the agency started bringing fewer cases through its administrative process, said C. Dabney O'Riordan, a partner in Quinn Emanuel Urquhart & Sullivan LLP's Washington and Los Angeles offices and former head of the SEC's enforcement division's asset management unit.

In the Lucia case, the Supreme Court found that ALJs at the time were improperly appointed. The SEC then reappointed its ALJs in a constitutionally appropriate way, but constitutional challenges to the ALJ systems have since ramped up, Ms. O'Riordan said.

But in issuing its 2018 decision in the Lucia case, the Supreme Court did not tackle the question of whether the ALJs as a whole were constitutional, particularly when it comes to how they can be removed from office. Lucia and others since have argued that ALJs have unconstitutional removal protections because the president couldn't simply fire them.

Once the Lucia case was decided and the ALJs were reappointed, it wasn't surprising that the people whose administrative proceedings had to be reconsidered by the commission "immediately raised the removal issue as a constitutional challenge," Ms. O'Riordan said.

That's exactly what Ms. Cochran did.

But another case — Jarkesy vs. SEC — could have even greater implications for SEC enforcement.

In May 2022, the Fifth Circuit ruled that the SEC's ALJ system was unconstitutional. Specifically, the decision found that the SEC's use of ALJs violated the right to trial by jury, that Congress unconstitutionally delegated to the SEC the power to decide whether securities fraud cases were heard in federal courts or before an ALJ, and that the removal protections given to SEC ALJs were unconstitutional.

The SEC has filed a cert petition asking the Supreme Court to take up the case, but the court has yet to announce whether it will do so.

It's likely that the court will hear the case, said Jay A. Dubow, Philadelphia-based partner at Troutman Pepper Hamilton Sanders LLP who co-leads the firm's securities investigations and enforcement practice group. He pointed to a concurring opinion issued by Justice Clarence Thomas in the Cochran case that said he has "grave doubts about the constitutional propriety of Congress vesting administrative agencies with primary authority to adjudicate core private rights with only deferential judicial review on the back end."

The Jarkesy case "goes right to what Justice Thomas said in his concurring opinion," Mr. Dubow said.

Whether or not the Supreme Court takes up the Jarkesy case or a similar case at a later point, ultimately the constitutionality of the ALJs is "going to have to be decided by the Supreme Court," Ms. O'Riordan said.

For now, the SEC will likely continue to bring more cases in federal court instead of in-house, sources said. But there are certain cases that can only be brought administratively, such as efforts to bar or suspend a professional, like an accountant or attorney, from practicing before the SEC, and those cases will likely face challenges.

"A respondent in an SEC administrative proceeding is probably going to make constitutional challenges given the number of questions that are outstanding, so what's going to happen is any sort of administrative enforcement action by the commission is going to be delayed while the constitutional challenges are played out in the district court," Ms. O'Riordan said.

That landscape may "make it harder for the SEC to strong-arm settlements (to which) individuals and companies might not otherwise agree," Mr. Schultz said.

Mr. Dubow noted that the SEC under the current administration has been seeking higher penalties for alleged wrongdoing, which also could lead more people and companies to decide it's worth it to fight the case rather than settle. In contested enforcement matters, the SEC authorizes an action seeking certain amounts of financial remedies from an alleged wrongdoer, but it's up to the court to decide the amount, Mr. Dubow explained.

In fiscal year 2022, the SEC enforcement division posted a record $6.4 billion in penalties and disgorgement, up from $3.9 billion the previous year.