A recent federal appeals court ruling that halted the Financial Industry Regulatory Authority's power to collect old disciplinary fines through judicial proceedings has effectively called into question the power all self-regulatory organizations have in enforcing fines through court action.
“It's a landmark decision to stop regulatory expansion of authority FINRA doesn't have,” says Martin Kaplan, head of securities litigation at law firm Gusrae Kaplan Nusbaum and the plaintiff's attorney in the case.
The case, Fiero v. FINRA stems from a 1998 enforcement action that FINRA—formerly known as the National Association of Securities Dealers—brought against now-defunct brokerage firm, Fiero Brothers, and its sole registered representative, John Fiero, over illegal short-selling allegations. Ultimately, FINRA expelled the firm, barred Fiero from associating with any member-firm or broker, and further imposed a $1 million fine.
After Fiero repeatedly refused to pay the fine, FINRA sued him in New York state court in 2003, and won a judgment against him for $1.3 million. A back-and-forth appeals battle ensued in both state and federal court, with the New York Court of Appeals finding in favor of Fiero, and the U.S. district court finding in favor of FINRA. The final straw was drawn on Oct. 5, when the 2nd Circuit Court of Appeals reversed the district court's decision and, siding with the New York Court of Appeals, dismissed the case for lack of subject matter jurisdiction.
Foremost, the court reasoned that Section 15A of the Securities Exchange Act, which governs the statutory authority and obligations of self-regulatory organizations, gives SROs the power to levy disciplinary fines against their members—but it does not give SROs the authority to bring judicial actions to enforce the collection of those fines.
“We fought this case a long time before the court reached this point,” Kaplan says. “The court was well-reasoned, and the concept of all governing, rather than regulators governing, is very critical.”
Some say the decision likely caught FINRA off-guard. “I don't think FINRA would have expected that the court wasn't going to back them up,” says Linda Riefberg, special-counsel resident at law firm Fried Frank, and former chief counsel for FINRA. “What good is it to have the authority to impose the sanction, if you can't get that sanction converted into a collectible judgment?”
“We fought this case a long time before the court reached this point. The court was well-reasoned, and the concept of all governing, rather than regulators governing, is very critical.”
—Martin Kaplan,
Managing Member,
Gusrae Kaplan Nusbaum
In its opinion, the court explained that nothing in the statute suggests that Congress intended to give FINRA authority to bring judicial actions to enforce its fines. The statutory scheme “carefully particularizes an array of available remedies, including permissible actions in the federal courts,” the court said. “Had Congress intended judicial enforcement, it would surely have provided for some specific relief other than leaving SROs to common law proceedings in state courts or in federal district courts under diversity jurisdiction.”
Additionally, the court stressed that FINRA fines already are enforced by a “draconian sanction” not involving court action—namely, barring that person from his professional livelihood. “When a member fails to pay a fine levied by FINRA, FINRA can revoke the member's registration, resulting in exclusion from the industry,” the court said. “Moreover, where a fine is based on a violation of the Exchange Act, the violator also will face a panoply of private and SEC remedies.”
In that regard, the decision won't have much influence on member firms, because the potential for expulsion from the industry is incentive enough to pay the fines that SROs impose. Where the decision will have significant effect, securities experts agree, is on those individuals whacked with severe penalties who can afford to walk away from the industry as an alternative to paying a fine.
“How many people previously left the industry and still paid, because they thought somebody would come after them for that fine?” Riefberg asks. “Were there people who were paying the sanction who maybe now wouldn't pay, because they doubt it's going to be imposed in court?”
REGULATORY ACTIONS
The chart below from FINRA's Statistical Review 2006 to 2010 examines the number of regulatory actions during that period:
Source: FINRA.
FINRA says that question is a non-issue, since the agency usually does not pursue barred individuals for unpaid fines. According to FINRA spokeswoman Nancy Condon, FINRA has filed only five court judgments since 2000, including the Fiero case. “The decision will not have any impact on, or restrict, our ability to enforce FINRA rules and securities laws, to discipline firms, or to protect investors,” she adds.
But that doesn't answer another question, Riefberg says: What happens with restitution in the event a firm decides to close up shop? “The firm can walk away because they know nobody is going to enforce anything against them,” she says. “That could result in investor harm, because those investors won't get that restitution.”
SROs Scrutinized
The court also found that a rule FINRA adopted in 1990, granting itself authority to pursue other available means for the collection of fines and costs imposed in disciplinary decisions, is not valid, because it was never properly enacted.
For an SRO to adopt a substantive rule change, that change must first be filed with the Securities and Exchange Commission and undergo a notice and comment period. An exception is granted for “housekeeping” provisions, which constitute stated policies with respect to the enforcement of an existing rule; those don't require SEC approval. FINRA invoked that exception for this particular rule change, skipping the notice and comment period.
The court, however, disagreed with FINRA's decision to characterize that rule change as a housekeeping item. The court reasoned that prior to 1990, no existing statute or regulation authorized SROs to file judicial proceedings to enforce the collection of disciplinary fines. Additionally, the court added, FINRA has a longstanding practice of not seeking to enforce collection through judicial actions. Conclusion: the rule change was actually a substantive one, which did not go through the proper approval channels, and therefore isn't enforceable.
What the decision says is that SROs cannot expand their authority without following certain procedures. “A regulator can't say, ‘I will it and, therefore, I have greater authority than Congress or the SEC has conferred on me,'” Kaplan says. “If that's the case any regulator can make up anything they want along the way.”
The degree to which FINRA oversteps its boundaries is an issue “that rarely gets determined, because very few respondents in FINRA matters have the wherewithal to be able to wage a battle,” Kaplan says. That could all change.
The decision may now give members incentive to scrutinize more closely all “housekeeping” provisions that are brought under judicial consideration. “That's what people are going to be analyzing going forward when they are challenged by certain rules,” Riefberg says. “That may be a threshold question that any other attorney might be asking when they are defending a case.”
As far as what happens next, FINRA spokesman Condon says, “we will continue to weigh our options.” Those options could include seeking review by the U.S. Supreme Court, or getting Congress to authorize FINRA to seek enforcement of its fines in court.
A final option left open by the decision may be for FINRA to seek such authorization through the notice and comment rulemaking process. Given the small number of cases FINRA has filed, however, that option hardly seems worth the effort. It may be that FINRA sees its membership leverage as threat enough for paying a disciplinary fine.
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