Supreme Court review will bolster fairness of SEC’s in-house judges

Whichever way​ the Supreme Court rules in Lucia v. SEC, the decision should improve the fairness of proceedings before the regulator’s administrative law judges.

If the court should find in favor of Raymond Lucia, who is appealing a decision by an SEC judge who fined him $300,000 and barred him from working as an investment adviser, the decision could affect more than 100 pending cases to appear before administrative law judges. It might even spark appeals of cases already decided by ALJs.

The fact that the Supreme Court sees an issue with how administrative law judges have been hired means the methods might not be constitutional and therefore their rulings might not be valid either. That is the crux of Mr. Lucia’s appeal.

The problem arose because, since passage of the Dodd-Frank financial reform law, the SEC has brought more and more enforcement actions before its in-house judges — the percentage increased to 80% from 60% before the reform law. Between 2010 and 2015, the SEC won 90% of those cases brought before in-house judges, versus 69% of its cases tried in federal court.

In addition, Dodd-Frank granted the administrative law judges authority to impose monetary penalties against any and all individuals, including foreign entities, that engage in securities fraud. They can also bar individuals from the securities industry and order disgorgements of illegal profits.

In 2014, the SEC collected almost $1.4 billion in fines and almost $2.8 billion in disgorgements. Before Dodd-Frank, the administrative law judges were limited to imposing civil penalties in enforcement actions involving registered entities and individuals.

(More: SEC enforcement of advisers drops in Trump era)

Those challenging the constitutionality of the administrative law judges argue this increase in powers means the judges are not merely agency employees but were inferior officers of the United States, who must be appointed by the president, a court or the head of a department, such as the chairman of the SEC, who requires congressional confirmation.

Two federal district court judges found merit in the argument that the judges were inferior officers of the U.S., but the U.S. Court of Appeals for the 11th Circuit disagreed, sending the issue to the Supreme Court.

In November, the SEC announced it had ratified the prior appointment of its five administrative law judges and had directed them to review their prior actions in all open administrative cases, an apparent concession by the SEC that all was not right with its previous hiring process.

The agency had previously taken small steps to make the hearings before administrative law judges fairer, by giving parties involved in a case more time to prepare prior to a first hearing and allowing them to take a limited number of depositions, among other reforms.

But the hearings still gave the appearance of being unfair, as both the SEC and the administrative law judges believed the judges were merely employees of the SEC. It would be hard for an employee to find against the employer, which is to say, there has been an apparent conflict of interest in the administration of justice by the SEC’s in-house courts.

Now, because the SEC has changed its hiring process, in effect admitting the judges are inferior officers, it will no longer be viewing them merely as civilian administrative employees. This will be reinforced if the Supreme Court should rule the judges were and are inferior offices of the United States. The judges have gained a modicum of at least psychological independence and likely will feel less pressure to rule in favor of the SEC. That should result in fairer hearings for those the SEC initiates actions against.

Even if the Supreme Court rules against Mr. Lucia, the change in the hiring process and the Supreme Court’s attention should result in a better process.

Related Topics: Securities and Exchange Commission