Supreme Court Declares SEC In-House Tribunals Unconstitutional in Pivotal Ruling

In a landmark decision on June 27, 2024, the United States Supreme Court declared that the U.S. Securities and Exchange Commission’s (SEC) use of in-house tribunals is unconstitutional. This ruling, which emerged from the SEC v. Jarkesy case, has profound implications for the SEC’s enforcement practices and the broader regulatory landscape. The Supreme Court’s 6-3 decision effectively ends the SEC’s long-standing practice of resolving fraud cases through in-house tribunals overseen by Administrative Law Judges. This development is especially significant for investment managers, who now face a new legal environment where the SEC’s authority to adjudicate cases internally is substantially reduced. In this article, Arootah Advisor Michelle McGurk delves into the ruling, explores its impact on investment managers, and considers its broader implications for the future of regulatory enforcement in the financial sector.

The Supreme Court’s Decision in SEC v. Jarkesy

The case of SEC v. Jarkesy centers on the SEC’s practice of using administrative law judges (ALJs) in in-house tribunals to adjudicate enforcement actions. George Jarkesy, a hedge fund manager charged with securities fraud, challenged the SEC’s decision to bring an enforcement action against him before an ALJ rather than in a federal court. Jarkesy argued that using in-house tribunals violated his constitutional right to a jury trial under the Seventh Amendment, which guarantees this right in cases where legal rights are adjudicated.

The Supreme Court, in a 6-3 decision, sided with Jarkesy, declaring that the SEC’s practice of using ALJs to decide cases involving civil penalties was unconstitutional. The Court held that such cases must be tried in federal courts where defendants have the right to a jury trial. The ruling is a significant blow to the SEC, which has relied on its in-house tribunals to handle many enforcement cases efficiently.

The Court’s decision was grounded in the constitutional separation of powers, emphasizing that federal agencies, like the SEC, should not have the power to prosecute and adjudicate cases. The ruling reflects a growing skepticism within the judiciary about federal agencies’ expansive powers and a trend toward reining in these powers to protect individual constitutional rights.

Key Aspects of the Ruling

1. The Right to a Jury Trial

The Supreme Court’s ruling reinforces the Seventh Amendment’s guarantee of a jury trial in civil cases where legal rights are at stake. By declaring the SEC’s in-house tribunals unconstitutional, the Court emphasized that cases seeking civil penalties must be decided by a jury in a federal court. This aspect of the ruling is particularly significant because it reasserts the importance of jury trials in the American legal system, especially in cases involving significant financial penalties.

2. The Separation of Powers

The ruling also underscores the importance of the separation of powers in the U.S. Constitution. The Court’s decision reflects concerns about the concentration of power within federal agencies, which have often acted as both prosecutor and judge in enforcement actions. By requiring that cases seeking civil penalties be tried in federal courts, the ruling shifts some of this power away from federal agencies and towards the judiciary, reinforcing the system of checks and balances.

3. Implications for Administrative Law Judges (ALJs)

The ruling questions the future role of ALJs within federal agencies. While the verdict specifically targets the SEC’s use of in-house tribunals, it could have broader implications for other federal agencies that use ALJs to adjudicate enforcement actions. This could lead to increased scrutiny of the use of ALJs in different contexts, potentially resulting in further limitations on their powers.

Implications for Investment Managers

The Supreme Court’s ruling has substantial implications for investment managers, who must now consider how the decision will affect their interactions with the SEC and other regulatory bodies. Below are some key considerations for investment managers in light of the ruling.

1. Increased Litigation in Federal Courts

One of the most immediate impacts of the ruling is the expected rise in litigation in federal courts. With the SEC now required to bring cases seeking civil penalties to federal courts, investment managers could face a more complex and time-consuming legal process. Federal court cases generally involve more extensive discovery, strict adherence to the Federal Rules of Evidence, and the potential for jury trials, all of which introduce more significant uncertainty and unpredictability in case outcomes. This shift may require investment managers to reassess their legal strategies and allocate more resources to compliance and legal defense.

2. Changes in SEC Enforcement Strategy

The ruling is likely to prompt changes in the SEC’s enforcement strategy. The agency may become more selective in the cases it chooses to pursue, focusing on those with a strong likelihood of success in federal court. While this might reduce the overall number of enforcement actions, the pursued cases may become more intense and complex. As a result, investment managers should be more vigilant in their compliance efforts to avoid becoming targets of such high-profile enforcement actions. The SEC may also explore alternative enforcement mechanisms, such as negotiated settlements, to resolve cases without going to trial.

3. Implications for Regulatory Uncertainty

The ruling introduces new regulatory uncertainty for investment managers. With the SEC’s traditional enforcement mechanism now under scrutiny, there may be an adjustment period as the agency adapts to the new legal landscape. This uncertainty could affect how investment managers approach compliance, risk management, and regulatory interactions. To navigate this uncertainty, investment managers may need to engage more actively with legal counsel and regulatory experts to stay informed about the latest developments and ensure their compliance programs align with the evolving regulatory environment.

4. Broader Impact on Other Regulatory Agencies

The Supreme Court’s ruling could have broader implications beyond the SEC, potentially affecting other federal agencies that use in-house tribunals to adjudicate enforcement actions. Agencies such as the Federal Trade Commission (FTC), the Consumer Financial Protection Bureau (CFPB), and the Commodity Futures Trading Commission (CFTC) may face similar challenges to their use of ALJs. This could lead to a broader shift in the regulatory landscape, with more enforcement actions being brought in federal courts rather than through administrative proceedings, creating new legal challenges and opportunities for investment managers.

Strategic Considerations for Investment Managers

This significant shift necessitates strategic adjustments across compliance, legal preparation, regulatory engagement, and continuous monitoring of legal developments. Here are some key strategic considerations to help investment managers navigate this evolving landscape effectively:

1. Strengthening Compliance Programs

Given the increased likelihood of federal court litigation, investment managers should prioritize strengthening their compliance programs. This includes conducting regular audits, enhancing employee training, and implementing robust internal controls to detect and prevent potential violations. Well-documented compliance efforts can be critical in defending against SEC enforcement actions and demonstrating a firm’s commitment to regulatory compliance.

2. Preparing for Federal Court Litigation

Investment managers should collaborate closely with legal counsel to prepare to defend against SEC enforcement actions in federal court. Developing a litigation strategy that addresses the challenges and opportunities of federal court proceedings, including broader discovery and the need to present a compelling case to a jury, is essential. Alternatively, dispute resolution mechanisms, such as mediation or arbitration, may provide a more efficient and cost-effective way to resolve disputes.

3. Engaging with Regulators

Proactive engagement with the SEC and other regulators is crucial for investment managers to stay informed about enforcement priorities or procedure changes. Participating in industry consultations, providing feedback on proposed regulatory changes, and maintaining open lines of communication with regulators can help firms stay ahead of enforcement actions and build stronger relationships with regulatory bodies.

4. Monitoring Legal and Regulatory Developments

Investment managers should closely monitor developments following the SEC v. Jarkesy ruling, including subsequent court decisions, regulatory guidance, and legislative changes that could impact their operations. Staying informed about these developments allows firms to anticipate potential challenges and opportunities and adjust their strategies accordingly.

The Bottom Line

SEC v. Jarkesy marks a pivotal shift in securities law enforcement, necessitating greater preparation for jury trials in federal courts. Investment managers must reinforce compliance programs and anticipate a more rigorous public defense process. As the SEC and other agencies adapt, firms need to stay ahead of enforcement changes and maintain vigilance in compliance to navigate the evolving regulatory environment effectively.

This ruling could redefine administrative proceedings, challenging the balance between bureaucratic efficiency and judicial oversight. Agencies and firms alike will need to adjust to this new reality, which will have far-reaching impacts on regulatory enforcement in the years to come.

Learn more about how Arootah’s advisory services can help you navigate this new regulatory landscape and achieve excellence in compliance and enforcement practices.