The U.S. Supreme Court will hear a case in its next term that has the potential to end the Securities and Exchange Commission's use of in-house judges to adjudicate enforcement proceedings, a move that would likely cause procedural headaches at the SEC, sources said.
The Supreme Court on June 30 agreed to hear Jarkesy vs. SEC, a case challenging the constitutionality of the SEC's administrative law judges, or ALJs, which handle administrative enforcement cases in-house.
The SEC petitioned the court to review the case following a May 2022 decision from the 5th U.S. Circuit Court of Appeals in New Orleans that sided with the plaintiff and 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 because the president couldn't simply fire them.
The court's next term begins in October. A date for oral arguments has yet to be announced.
"What's looming is the possibility of losing the ability for (the SEC) to use the administrative process for its enforcement actions or have it severely limited," 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 noted that administrative process is typically quicker and less burdensome for the SEC when compared to enforcement proceedings in federal court.
Administrative law judges, which are appointed by the president, are well-versed in many of the complex issues in the securities industry and, in particular, the professional standards for those registered with the SEC, sources said.
An SEC spokesman declined to comment on the Supreme Court taking up the Jarkesy case and the constitutionality of the agency's ALJ system.
The SEC began investigating George R. Jarksey Jr. in 2011 after he selected Patriot28 as the investment adviser for two hedge funds he managed. The SEC alleged that Mr. Jarkesy and Patriot28 committed securities fraud and in 2013 instituted an administrative enforcement action against the two parties before an administrative law judge. Mr. Jarkesy subsequently sued the SEC arguing that the agency's structure and administrative enforcement powers violated the Constitution, according to a Troutman Pepper client alert.
The lawsuit has now found its way to the Supreme Court and could impact not just the SEC, but all federal agencies that use ALJs, including the Federal Trade Commission and Commodity Futures Trading Commission, according to Mr. Dubow.
As challenges to the SEC's ALJ system sprung up in recent years, the agency began bringing more cases in federal court instead of in-house, a trend that legal experts expect to continue at least until after the Supreme Court's decision in the Jarkesy case.
But those challenges so far have not slowed down SEC enforcement. 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.
If the court were to rule in the SEC's favor in the Jarkesy case, the agency would likely bring more cases through the 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, though sources don't expect such a ruling in this case.
In April, the Supreme Court unanimously ruled against the agency in SEC vs. Cochran, a case that focused on a procedural issue involving the SEC's use of ALJs. In that case, 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 had to go through a lengthy administrative process before bringing a case to challenge the constitutionality.
The Cochran case changed that precedent.
In light of the Cochran decision, the 5th Circuit's ruling in the Jarkesy case, a 2018 Supreme Court decision in Lucia vs. SEC that found that ALJs at the time were improperly appointed, and the conservative leaning Supreme Court, sources expect another ruling against the SEC in Jarkesy.
"This current makeup of the Supreme Court is one that could go against the ALJ process," 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.
Added Mr. Dubow: "The consensus is that the court's going to rule against the SEC."
Of note, Justice Clarence Thomas in a concurring opinion in the Cochran case said that 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."
If the Supreme Court decides the ALJ system is unconstitutional, the SEC will be in an uncertain position, sources said. As it currently stands, 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.
If the administrative process is deemed unconstitutional, there are questions around how those cases can be resolved. The SEC would likely need some sort of legislative fix from Congress, but the nature of the legislative fix would depend on how the court rules on the various challenges to the administrative process, Ms. O'Riordan said.
But in a divided Congress, lawmakers crafting a bill that can pass both the House and Senate will not be a simple task, she added. "A legislative fix would likely be very difficult right now," she said.
