Two recent decisions have put the US Securities and Exchange Commission’s (SEC) in-house administrative proceedings in the crosshairs. First, on May 16, 2022, the US Supreme Court agreed to consider whether Administrative Law Judges (ALJs) operating at the SEC are unconstitutionally protected from removal from office. Then, on May 18, 2022, in a stunning decision, the Fifth Circuit found the SEC’s judgment against a hedge fund manager and his company was unconstitutional because the administrative proceedings violated their right to a jury trial and relied on unconstitutionally delegated legislative power. On the heels of the disclosed breach in its adjudication database by Enforcement staff, the heat is rising on the SEC’s entire in-house adjudication system.

The first case was brought against the SEC by Michelle Cochran, an accountant who in 2016 faced disciplinary action based on accusations that she and her former firm had failed to conduct annual audits and quarterly reviews in violation of Public Company Accounting Oversight Board Standards. The ALJ in the initial in-house SEC proceeding against her sided with the agency, imposing a five-year ban on Cochran practicing as an accountant before the SEC and ordering her to pay a $22,500 fine. Cochran is now arguing that ALJs are unconstitutionally appointed and protected from removal by the President.[1]

The Supreme Court takes up this matter following an en banc ruling by the Fifth Circuit, permitting Cochran to challenge the constitutionality of SEC-appointed ALJs. In the December 2021 decision, the Fifth Circuit held that The Securities Exchange Act of 1934 did not strip federal district courts of their jurisdiction over structural constitutional challenges to administrative proceedings, and did not require Cochran to make her constitutional arguments to the ALJ before she could appeal to federal court, as the ALJ and a split Fifth Circuit ruling had previously held.

The Court will hear Cochran’s argument in the wake of its 2018 decision in Lucia v. SEC, which also considered the constitutionality of the ALJs at the SEC.[2] There, the Court held that ALJs were inferior officers of the United States subject to the Appointments Clause, requiring that ALJs be appointed by the President or other delegated officers. Given the agency’s practice of hiring through an in-house process, the Court found that the SEC’s ALJs had not been appointed constitutionally. In response, the SEC rectified the ALJ appointments and ordered new hearings in affected proceedings.[3] The Court in Lucia did not, however, opine on whether the Administrative Procedure Act’s statutory restrictions on removing ALJs were constitutional. Cochran asks the Court to answer that question, as she asserts the statutory tenure protections conflict with the Appointments Clause.

Another shadow will loom large over the Court’s decision in Cochran: a recent 2-1 decision by the Fifth Circuit finding that the SEC’s administrative proceeding against a hedge fund manager and his company was unconstitutional.[4] On May 18, 2022, the court said the agency’s in-house administrative proceeding violated a hedge fund manager’s right to a jury trial, and the authority of the presiding ALJ relied on legislative power that had been unconstitutionally delegated to the SEC. The court additionally held that statutory protections which insulated the SEC judges from removal by the President violated the Take Care Clause of Article II.

The majority was careful to note, however, that not all in-house adjudication of claims was violative. They clarified that it was constitutionally permissible for the SEC to preside over cases that centered on “public rights,” that is, “a right so closely integrated with a comprehensive regulatory scheme that the right is appropriate for agency resolution.”[5] But because “[s]ecurities fraud actions are not new actions unknown to the common law,” the at-issue proceeding was “akin to traditional actions at law to which the jury-trial right attaches” and was “not uniquely suited for agency adjudication.”[6] One of the key factors the court relied upon in its analysis was that the SEC was seeking a legal remedy—a civil monetary penalty. While the court did not hold that the SEC could never seek civil monetary penalties in its in-house proceedings, this decision suggests that the SEC would have to pursue such case in federal court.

These decisions come at a time when the SEC is already facing intense scrutiny of its in-house proceedings, after admitting to a control breach related to the separation of its enforcement and adjudicatory functions.[7] For a period of time, certain databases were not configured to restrict access by Enforcement staff to documents and memoranda created by Adjudication staff. In some cases, the documents were even uploaded to an Enforcement database, potentially influencing enforcement filings and decisions. Remarkably, both the Cochran and the Jarkesy cases were impacted by the breach, with each case having had memoranda inappropriately accessed, shared, and uploaded. The SEC reported, however, that its internal review found no evidence that Enforcement staff in those two cases actually reviewed the adjudication memos or otherwise impacted any Enforcement filings.

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Since Congress expanded the SEC’s authority to pursue enforcement actions in its in-house administrative proceedings, most recently through the Dodd-Frank Act, the SEC has favored the use of those proceedings over federal court in bringing enforcement actions.[8] Such increased use heightened concerns over the fairness of the proceedings because of the potential for perceived bias in a system in which the SEC acts as prosecutor, judge, and appellate court. In one week, not only has the constitutionality of the SEC’s ALJs been put on the line, but the viability of the agency’s administrative proceedings for certain claims and remedies has been called into question 

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