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When Your SEC Prosecutor Is Your Judge, Scandals Surely Follow

Aug. 3, 2022, 8:45 AM

“Agencies that combine enforcement and adjudication—as many do—are unconstitutional. But convenient for the government,” law blogger Glenn Harlan Reynolds posted earlier this year. For those who follow SEC enforcement, particularly adjudication by in-house administrative law judges, two recent cases from the US Court of Appeals for the Fifth Circuit may change all that.

Michelle Cochran, a Texas CPA who quit her small accounting firm in 2013, was blindsided in 2016 by SEC charges of violating federal accounting standards for what are commonly called paperwork violations. She opposed the claims, pointing out that none of her audits ever had to be restated, and no clients or shareholders ever complained or alleged any harm. Because the relevant audits occurred at least three years prior to the hearing, she had no control over them and no way to verify whether they were complete.

Despite acknowledging her difficult working conditions, the SEC ALJ ruled against her, imposing a $22,500 fine and a five-year industry bar. That initial decision was vacated in 2018 following the US Supreme Court’s decision in another SEC case holding that her ALJ had not been constitutionally appointed. Rather than endure a second rehearing before a new SEC ALJ who still enjoyed unconstitutional multiple tenure protections, Cochran sued in federal district court. That court denied jurisdiction, prompting Cochran to appeal and eventually an en banc rehearing before the Fifth Circuit.

Cochran v. SEC, decided in December 2021, broke ranks with nearly a decade of circuit court decisions across six circuits. Those previous decisions had illogically—and counter to clear Supreme Court precedent—required enforcement targets, seeking to raise these constitutional challenges, to first undergo unconstitutional administrative proceedings before reaching a federal court competent to rule on the constitutional questions. The full circuit court held 9-7 that these constitutional challenges could and should be brought in federal courts before enforcement targets had to endure administrative proceedings. Because the decision created a circuit split, the Supreme Court will hear Cochran next fall.

The second case, Jarkesy v. SEC, involved administrative claims that George Jarkesy, a radio host who managed two hedge funds, had committed securities fraud by allegedly misrepresenting the funds’ investment parameters, safeguards, valuations, fees, and management. Jarkesy came to the Fifth Circuit after going through the full administrative mill, a process that took seven years. After Jarkesy had endured his administrative proceeding, a Fifth Circuit panel held in May 2022 that those proceedings must be vacated because they denied him his constitutional right to a jury trial, and unconstitutionally delegated legislative power to the SEC to decide who gets to be tried in a real court and who must endure the ALJ system. Finally, Jarkesy held that SEC ALJs are unconstitutionally protected from removal in violation of the Take Care Cause of Article II of the Constitution, the same question on which Cochran seeks a judicial decision.

The two cases have rocked the world of administrative law. But Michelle Cochran and George Jarkesy have another thing in common that has received remarkably little to no media attention.

‘Control Deficiency’

In early April 2022, just hours after Cochran agreed to stays of her proceedings pending Supreme Court certiorari, the SEC filed a disclosure identifying “a control deficiency” that established that its in-house prosecutors had illegally accessed files belonging to its in-house judges. The SEC filed an identical disclosure in Jarkesy’s pending Fifth Circuit appeal.

While “control deficiency” sounds like the kind of dull bureaucratic occurrence that warrants little attention from the public, this statement and the actions that required it are anything but. To put it bluntly, this is like the judge and their law clerks in an ongoing proceeding leaving a bench brief where the prosecutor might find it. In multiple matters, the accessed memoranda were uploaded into a database accessible to all SEC Enforcement Division staff.

This breach in protocol imperiled the due process rights of anyone accused by the SEC and underscores the core constitutional problem with agency adjudications: When an agency is both the prosecutor and the adjudicator, there can be no fair hearing.

It is unclear from the statement how many actions were compromised, but the SEC admits there are cases other than Cochran and Jarkesy. We don’t know how long the access was available or how long the commission knew about the access before it was publicly disclosed in April. And yet this was only disclosed once Cochran agreed to a stay of proceedings, and Jarkesy was fully briefed and argued at the Fifth Circuit.

The SEC statement takes a “no harm, no foul” view of the breach that is long on self-exculpatory statements and short on facts and details. Worse, the commission retained a private consulting firm, Berkeley Research Group, to investigate. Public records show BRG regularly serves as an expert witness on behalf of the SEC in its own enforcement actions under contracts amounting to millions of taxpayer dollars.

So the SEC seriously thinks it is proper to hire a company with a conflict of interest to investigate its internal conflict of interest? By hiring this conflicted outside investigator, the SEC further circumvented its own inspector general, avoiding pesky things like mandatory criminal referrals to the Department of Justice and detailed reports to Congress. Imagine the fate of an SEC target that hired a long-time vendor to investigate its internal control deficiencies, and the vendor promptly announces there’s “nothing to see here” before the breach is disclosed to the injured parties.

Several years back, an SEC ALJ alleged that she had been admonished for showing insufficient loyalty to the agency and that ALJs were pressured to shift the burden of proof to respondents. Another bragged that he always found in favor of the agency that employed him and levied maximum penalties on anyone with the temerity to contest SEC charges and other charges of disturbing ALJ conduct. That subsequent investigatory report also exonerated the agency. A recent GAO study said that most Patent Trial and Appeal Board judges, similarly situated as in-house judges, report they have felt pressure to alter rulings.

Conclusion

In-house agency adjudications deprive parties of due process of law precisely because they fail to keep the prosecutorial and adjudicatory functions structurally separate. As this scandal highlights, the right to unbiased, disinterested, and independent prosecutors and adjudicators is jeopardized—and always will be—when these functions are combined in a single agency. When investigatory, prosecutorial, and adjudicatory powers are concentrated in a single agency, the opportunity for constitutional harm abounds. Tax professionals should watch these cases closely because the SEC has a 100% win rate in its in-house courts, whereas it only wins 61% of its federal court cases with jurors as the triers of fact.

It is time to restore the separation of prosecutorial and adjudicative powers, which the Founding Fathers rightly understood to be central to our liberty. This should start with a truly independent review of the commission’s breach, but it should end with returning all adjudication to Article III courts.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Peggy Little is senior litigation counsel and Kara Rollins is litigation counsel at the New Civil Liberties Alliance. NCLA has represented Michelle Cochran since 2018 in her fight for a constitutional tribunal.

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