Wall Street

Ms. Tilton goes to Washington: Can she beat the government?

Lynn Tilton, CEO of Patriach Partners.
Adam Jeffery | CNBC

By filing suit against the Securities and Exchange Commission, Lynn Tilton may be trying to launch a frontal assault against the new order of American securities regulation.

As it happens, a number of legal experts think she may have a point.

Last week, the SEC announced that it was bringing charges against the so-called "diva of distress" and her firm, Patriarch Partners. The regulator alleges that she obfuscated the poor performance of some loans, collecting $200 million in unearned fees and payments along the way. Her methods of valuation analysis also violated the methodology Tilton said she would follow in key documents, the SEC alleges.

Tilton has aggressively defended herself against the specific charges, telling CNBC last month that the SEC is bringing "an ill-founded case based on financial statement technicalities."

Read MoreTilton, Patriarch Partners file counter-suit against SEC

But at the same time, Tilton is bringing her own lawsuit against the SEC—and it's one that has little to do with the allegations of which she stands accused. Rather than take Tilton to district court, the SEC has ordered that a public hearing take place before an administrative law judge, who could rule that she pay a civil penalty, return money to investors, or impose other sanctions.

Tilton believes that this is unfair. More to the point, she believes the idea is constitutionally suspect—and some law experts tend to agree.

John Coffee, a Columbia Law School professor and an expert on securities regulation, points out that administrative law judges are used by a bevy of other federal agencies, from the Federal Trade Commission to the Coast Guard.

"It's a new use of this tool, but the tool itself has been used many times," Coffee said. "It might have some ability to get them a favorable settlement, but I don't think it has a good chance of succeeding in court."

The trouble with admin law judges

The current role of SEC administrative law judges is somewhat new. Post-crisis regulation in the 2010 Dodd-Frank Act greatly expanded the power of SEC administrative law judges: the SEC may now choose to bring many more cases as administrative actions rather than as federal cases. Fast-forward a few years, and the constitutionality of those proceedings are being hotly contested.

Tilton and Patriarch allege that the SEC's administrative law judge process violates Article II of the U.S. Constitution, which delineates the power of the president. The Supreme Court's recent interpretation of the Article is that officers of the president may not be separated from presidential supervision by more than one layer of tenure protection.

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Given that the special SEC judges may be removed only for good cause by another official who can only be removed for good cause, administrative law judges are unconstitutionally separated from the power of the president, Tilton's suit argues.

Nor is Patriarch the first to make this argument. A nearly identical lawsuit was brought last year by Joseph Stilwell—who was also being pursued by the SEC, and who also happened to retain the same white shoe law firm as Tilton, Skadden Arps. Yet Stilwell ultimately settled with the agency for less than $600,000 with no admittance of wrongdoing, an outcome Skadden boasted of as "favorable." Several other suits have brought forth the same claim.

The SEC declined to comment for this article. A representative for Skadden did not immediately respond to a request for comment.

See you in court?

So could Tilton actually prevail in her argument? Ira Sorkin, a defense attorney with Lowenstein Sandler who has represented white collar defendants from Bernie Madoff to Jordan Belfort's Stratton Oakmont, says there are several serious problems with SEC administrative law judges (ALJs) that the judicial branch may be eager to remedy.

"An administrative law judge who acts as judge and jury is in no position to decide novel applications of law," Sorkin said. "You want federal courts to determine what the law says."

Read MoreMark Cuban: I see 'red flag' in Tilton SEC case

Sorkin has several other criticisms of the process, including limited rights of information discovery and appeal, and the possibility that some administrative law judges may not have the expertise required to decide these complex cases.

"I don't want an ALJ to determine whether my client can be kicked out of the business, lose his livelihood, be fined, or see disgorgement," he said. "I certainly want a federal judge hearing that case."

In Sorkin's estimation, "the SEC has gone way overboard" with their use of ALJs, and "if you see enough of it, eventually it will get to the Supreme Court." (Tweet this)

'The court has to start thinking about this'

It is possible that Tilton's case could only be won in the Supreme Court, if it actually gets that far. Legal scholars say that while Justices Antonin Scalia and Clarence Thomas may have the appetite to hear such a case, few other justices would. That is partly because the ALJ administrative law judge system is so critical to regulatory procedure.

"The way the SEC is using ALJs is consistent with how they're used through the rest of the administration," said Kent Barnett, a professor at the University of Georgia School of Law who specializes in administrative law. "But whether it's actually constitutional is a different question."

Barnett says the issue is coming to the fore now because of Free Enterprise Fund v. Public Company Accounting Oversight Board, a 2010 case decided in a 5-4 Supreme Court vote. That's where the justices carved out the "more than one layer of tenure" interpretation of the Constitution's Executive Article.

Interestingly, it is in a mere footnote to Chief Justice John Robert's majority opinion that court dispenses with the can of worms the decision inevitably opened.

This decision "does not address that subset of independent agency employees who serve as administrative law judges.... many administrative law judges of course perform adjudicative rather than enforcement or policymaking functions, or possess purely recommendatory power," the footnote states.

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The comment seems to make two points: the court is well aware that if judges are enforcing the law or making policy, they are now on dicey constitutional ground. Simultaneously, it also suggests the current court wants to hear nothing more of the Article II complaint about administrative law judges.

In theory, however, if the high court did hear and find for Tilton in the case, then one glaring question remains: What would happen to all of the judgments already handed down by SEC administrative judges, not to mention the rulings of all the other administrative law judges in federal agencies?

If the Supreme Court ruled in favor of Tilton, "you would expect a whole slew of cases to pop back up," Barnett said.

"What would happen to them? Nobody knows. The court really has to start thinking about this," he added.