What the Supreme Court’s ruling in SEC v. Jarkesy means for investors

A recent Supreme Court ruling^[1] has gotten a lot of attention for how it could reshape government^[2]. What’s gotten much less attention is how it could affect markets.

As finance^[3] professors^[4], we find this at least as important. The Supreme Court’s 6-3 ruling in SEC v. Jarkesy^[5] could make it more challenging for the Securities and Exchange Commission – the U.S. agency that regulates securities markets – to fight fraud. And any time the SEC loses power, as it just did, market trust and transparency may be at risk.

What matters for investors, including anyone with a 401(k) plan, is how the SEC chooses to handle cases moving forward.

What is securities fraud, anyway?

Securities^[6] are investments like stocks and bonds, and securities fraud^[7] is a crime that involves misleading investors. Specifically, it is “the misrepresentation or omission of critical information to induce investors into trading securities,” according to the Legal Information Institute at Cornell University^[8].

Some people joke that “everything is securities fraud^[9],” because words like “misrepresentation” and “securities^[10]” are open to a lot of interpretation.

But even though those words can be defined broadly, the SEC prosecutes relatively few cases – those where it has the greatest likelihood of winning^[11].

What happened in SEC v. Jarkesy?

The story of SEC v. Jarkesy began with the 2008 financial crisis^[12], when a hedge fund manager in Texas^[13] watched the value of his funds decline.

In 2013, the SEC accused the fund manager – George Jarkesy – of committing securities fraud, alleging that he overestimated fund values and made other false claims. The SEC charged Jarkesy and fined him US$300,000 in a proceeding in an in-house SEC court overseen by an administrative law judge^[14].

Jarkesy then sued the SEC, claiming he hadn’t been granted a fair trial.

The case found its way before the Supreme Court, which ruled in Jarkesy’s favor. The ruling determined that the SEC proceedings used to identify fraud and impose fines didn’t meet the criteria for a fair trial. Moving forward, such cases will need to be tried in federal court.

It’s an important precedent for the defense of people accused of misdeeds by government agencies. And the SEC isn’t the only agency to use such internal administrative proceedings. More than two dozen other agencies^[15], including the Department of Labor and the Environmental Protection Agency, will be affected by the court’s ruling.

How will the ruling affect SEC enforcement?

Some people have argued the ruling won’t change much^[16] for the SEC, since the agency had already started routing many^[17] cases^[18] through federal courts. Additionally, the SEC has plenty of other opportunities to fight fraud through federal litigation, industry bars and suspensions^[19].

However, a ruling that the SEC now must turn to judiciary trials or proceedings instead of internal administrative proceedings^[20] will move all securities-fraud cases involving fines to the federal courts, potentially raising the cost of prosecution. That, in turn, could result in fewer enforcement efforts, given limited agency resources.

What’s more, losing the implicit home-court advantage the SEC previously had with its internal proceedings could further slow and complicate enforcement efforts. The result could be that when people commit securities fraud, the SEC won’t have the resources to ensure they’re caught and punished.

In the short term, the Supreme Court ruling avoided limiting the SEC’s power^[21] as much as some of the lower courts suggested it should. So at least the SEC kept most of its rule-making and enforcement authority.

How could the ruling affect markets?

To understand what will likely change, it’s important to understand the former status quo.

In the most recent fiscal year, 2023, the SEC filed 784 enforcement actions^[22], ordering nearly $5 billion in fines and distributing nearly $1 billion to harmed investors. That was a 3% increase in enforcement actions over 2022. And the past two years of SEC fines have been the largest^[23] on record^[24].

But now, the SEC cannot fine defendants through administrative courts and must seek civil penalties through federal courts.

One potential outcome could be a smaller regulatory burden for investment professionals who may have been concerned with how their actions would be viewed by the SEC – including, but not necessarily limited to, fraudsters. This is because the SEC may bring forward fewer fines or cases with fines due to the additional resources necessary for judiciary proceedings.

If that happens, fraudsters might be emboldened – since the expected cost of committing securities fraud would be lower than it was before the ruling – and investors would have to depend less on regulators protecting them and more on limiting risks themselves.

This could pose a problem for less sophisticated investors. Lots of people don’t know how to define securities fraud; even fewer can figure out whether a fund manager may have committed it. That risk, in turn, could limit the way investors participate in markets.

But if that simply means Americans buy more shares of S&P 500 exchange-traded funds^[25] and invest less in hedge funds^[26], it shouldn’t be a problem for anyone’s bottom line^[27]. And more sophisticated investors should be well-equipped to evaluate risks on their own.

At the end of the day, researchers have documented the importance of trust on market quality and efficiency^[28]. So whatever helps the SEC maintain trust will have the most value for markets.

Enforcement will remain key to maintaining transparency^[29] in markets, but the method of enforcement – be it in a federal court or elsewhere – may not matter very much. The important thing is that people who commit financial crimes continue to face consequences.

References

1. ^{^} recent Supreme Court ruling (www.supremecourt.gov)
2. ^{^} could reshape government (axios.com)
3. ^{^} finance (www.business.msstate.edu)
4. ^{^} professors (finance.appstate.edu)
5. ^{^} SEC v. Jarkesy (www.supremecourt.gov)
6. ^{^} Securities (www.law.cornell.edu)
7. ^{^} securities fraud (www.law.cornell.edu)
8. ^{^} the Legal Information Institute at Cornell University (www.law.cornell.edu)
9. ^{^} everything is securities fraud (www.bloomberg.com)
10. ^{^} securities (omny.fm)
11. ^{^} those where it has the greatest likelihood of winning (today.westlaw.com)
12. ^{^} the 2008 financial crisis (www.federalreservehistory.org)
13. ^{^} hedge fund manager in Texas (www.nytimes.com)
14. ^{^} administrative law judge (www.law.cornell.edu)
15. ^{^} More than two dozen other agencies (news.bloomberglaw.com)
16. ^{^} won’t change much (www.politico.com)
17. ^{^} many (www.sec.gov)
18. ^{^} cases (www.coindesk.com)
19. ^{^} federal litigation, industry bars and suspensions (www.sec.gov)
20. ^{^} internal administrative proceedings (www.bloomberg.com)
21. ^{^} Supreme Court ruling avoided limiting the SEC’s power (news.bloomberglaw.com)
22. ^{^} SEC filed 784 enforcement actions (www.sec.gov)
23. ^{^} largest (www.sec.gov)
24. ^{^} on record (news.bloomberglaw.com)
25. ^{^} S&P 500 exchange-traded funds (www.investopedia.com)
26. ^{^} hedge funds (www.ml.com)
27. ^{^} anyone’s bottom line (www.barrons.com)
28. ^{^} the importance of trust on market quality and efficiency (doi.org)
29. ^{^} Enforcement will remain key to maintaining transparency (link.springer.com)