Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Supreme court upends securities enforcement

The US Supreme Court ended a momentous term with two rulings certain to roil the complex federal regulatory framework. On June 27, the conservative majority upheld a lower court decision that voided a civil penalty imposed by the Securities and Exchange Commission on a corrupt investment advisor, finding that the agency did not have the constitutional authority to impose civil penalties without a jury trial.

The next day, the court broadened its sweep in sharply limiting the authority of all federal agencies to interpret and enforce the laws they are charged with administering, overturning 40 years of precedent, possibly precipitating a monumental overload of the federal judicial system. What comes next is uncertain, but investors will need to be especially conscientious as enforcement of securities regulations will be impacted.

The SEC, EPA, Department of Labor, FDA, and nearly two dozen other departments of the government rely upon a cadre of administrative law judges or ALJs who serve as executive magistrates adjudicating civil disputes between the agencies and those whom the agencies regulate. These judges are appointed by the agencies themselves and are therefore part of the Executive branch of the US government and not the Judicial branch. The Supreme Court majority held that allowing these ALJs to impose civil penalties violates the separation of powers and is therefore unconstitutional.

The original SEC case involved an investment advisor and talk radio provocateur named George Jarkesy, whom the agency found had defrauded investors and lied to regulators. An administrative law judge at the SEC imposed a stiff fine on the perpetrator and barred him from the securities industry.

Jarkesy appealed to the US Fifth Circuit Court of Appeals, which decided in his favor, ruling that the Seventh Amendment to the Constitution affords citizens the right to a jury trial in common law fraud cases. By a 6-3 vote, the Supreme Court affirmed the appeals court ruling and effectively stripped the SEC of its authority to impose civil penalties without going to court. Henceforth, the agency will have to bring charges before a federal judge to punish bad actors seeking to rip off their clients. Let the games begin.

The SEC rose from the ashes of the 1929 stock market crash that wiped out many investors and sank the economy for a decade. A frenzy of wild speculation in unregulated securities had prevailed throughout the 1920s, prompting noted economist Irving Fisher to opine that the market has attained what looked like “a permanently high plateau”. Well, not so much. Beginning on Black Monday, October 28, 1929, the Dow Jones index ultimately plummeted by nearly 90%, striking the match that ignited the conflagration known as the Great Depression.

In addition to the speculative fever, the market was rife with fraud and manipulation, highlighting the need for more transparency to restore investor confidence in the critical US system of capital formation. Congress responded by passing investor protection legislation including the Securities Exchange Act of 1934 that established regulations for stock exchanges and created the SEC to enforce those regulations.

President Roosevelt’s choice for the first SEC Chairman was an ironic one: Joseph P. Kennedy, Sr., the father of President Kennedy, whose considerable fortune was created in part through what we today would call insider trading and market manipulation, a 1920s version of meme stock traders pumping GameStop.

The recent landmark cases overturned a long-standing precedent known and the Chevron Doctrine, from a 1984 case involving the Environmental Protection Agency’s jurisdiction involving oil companies. The Supreme Court at the time recognized regulatory agencies’ authority to interpret and enforce federal statutes if Congress had provided no specific direction. The precedent was uncontroversial at the time and has been upheld by the court over seventy times since, as Justice Kagan noted in her dissent. But in recent years, conservative activists and corporations have pressed the court to overturn the precedent and notched a big victory with the decisions.

The future of regulatory enforcement is unclear. There are currently over 1,900 Administrative Law Judges hearing over 700,000 cases per year, compared with just 677 backlogged federal trial court judges who will now be required to take up at least some of the slack. The mind reels.

The expected surge in court cases will also require a huge increase in Congressional authorization to fund the courts and to beef up the legal staff at the SEC tasked with trying more fraud cases. The prospect of a constructive response from the current Congress seems dubious at best. One possibility is that the SEC may partner with state regulators to share some enforcement responsibility, or states may decide on their own to step up if federal oversight suffers significantly.

These decisions should serve as another reminder that individuals must do their homework before trusting a financial professional or committing to an investment. Begin by viewing the employment record, credentials, education, and disciplinary history of an individual or the compliance record of a firm by visiting Ask lots of questions, including how fees are calculated, how the representative gets paid, do they function as a fiduciary on your behalf, and how errors or disputes are resolved. These are questions that a reputable advisor or representative will be happy to address.

Regulation is a constant balancing act between adequate protection and oppressive overreach. The balance has recently shifted again and while we await the next equilibrium, investors should be especially vigilant.

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