2nd Circuit Holds that FINRA Lacks Statutory Authority and FINRA Rule was Invalid
The Securities Exchange Act of 1934 (the “Exchange Act”) authorizes the Financial Industry Regulatory Authority (“FINRA”) and other SROs to regulate within the securities industry. FINRA’s role includes registering and educating industry participants, examining firms, implementing rules, and enforcing them alongside the federal securities laws. FINRA’s enforcement tools include imposing fines for violations. Last week, in Firero v. FINRA, the United States Court of Appeal for the Second Circuit found that FINRA lacked the power to sue for unpaid fines.
Summary of Facts and Judgment
Fiero Brothers (the “Firm”) was a FINRA member and registered broker-dealer. John J. Fiero (“Mr. Fiero,” and together with the Firm, “Fiero”) was the Firm’s only registered representative. In 1998, FINRA brought an enforcement action against Fiero for engaging in illegal short-selling, among other violations. FINRA permanently barred and fined them $1 million, plus costs. For the next ten years, FINRA attempted unsuccessfully to collect the fine from Fiero. In 2003, FINRA filed suit in New York state court to recover the fine and costs. The lower courts found in FINRA’s favor; however, the New York Court of Appeals reversed, holding that the FINRA complaint fell under the exclusive jurisdiction of the federal courts.
Fiero then sought a declaratory judgement in federal district court, that FINRA lacked authority to collect fines through judicial proceedings. FINRA filed a counterclaim seeking to enforce its fine, and both parties moved to dismiss each other’s claims. The District Court entered judgment in FINRA’s favor, dismissing Fiero’s complaint. The Second Circuit reversed, holding that:
(1) the Exchange Act did not authorize FINRA to sue for fines, stating that the specificity of the statute, and omission of the power to sue indicated Congress’ intent to withhold this power from SROs. The court noted that FINRA’s longstanding practice did not include filing suits, and that the Fiero case was the first it had brought; and
(2) FINRA’s 1990 rule permitting it to sue for fines was improperly promulgated under the Exchange Act, specifically that it was not a “housekeeping rule” that is approved upon receipt of the SEC (as submitted by FINRA), but was instead a substantive rule, subject to notice and a comment period.
Implications of the Court’s Decision
Following the decision, FINRA’s general counsel reportedly stated that FINRA would “continue to review the ruling and weigh our options.”
Those options include seeking review by the United States Supreme Court, or asking Congress to provide SROs with the right to seek enforcement of their fines in court. In the meantime, FINRA may, and will, pursue collection of fines short of litigation, and suspend or bar violators from the industry. FINRA may seek the SEC’s assistance in obtaining court orders that include payment of fines. However, the decision hampers FINRA to the extent that fear of litigation inspired violators to pay their fines.
But some commentators have noted that FINRA seldom pursued barred individuals for unpaid fines, and rarely sued (one put the total number of lawsuits at five, including Fiero). Furthermore, violators who are not barred have an incentive to pay their fines if they wish to keep their licenses. Reactions were positive from those who believed that FINRA had been exceeding its statutory power for years, and abusing the rule-making process.
Rule-making is likely the area most impacted by the ruling. The court’s criticism that FINRA bypassed the notice and comment procedure may cause SROs and the SEC to scrutinize proposed rules, or second-guess existing “housekeeping” rules, to ensure that they are not substantive, and subject to a lengthy approval process. Moreover, future litigants may be encouraged to seek judicial review of SRO rules that were approved in the more streamlined process for “housekeeping” rules.
New York is home to many financial firms, and the courts there have expertise in interpreting the federal securities laws. Though not binding on other courts, the Second Circuit’s decision will be influential among the other federal circuits. State courts may follow the New York Court of Appeals, and decide that they do not have subject matter jurisdiction over collections cases involving federally-authorized SROs.
A remaining question is whether the decision will impact the proposed SRO for investment advisers, and FINRA as the candidate for that role. At this point, the particulars of that legislation and the SRO’s powers in collecting fines, is unknown. The decision is not expected to affect FINRA’s status as the frontrunner to fill this role.
Recent years have seen expanded regulation of the financial industry. Thus, it is surprising that the Second Circuit determined that FINRA lacked a particular enforcement tool. However, it is this climate of expanding regulation that may give FINRA the leverage to seek greater enforcement powers and options from Congress. In the meantime, and perhaps despite a FINRA spokeswoman’s comment that “the decision will not…restrict our ability to enforce FINRA rules and securities laws….,” at least some violators who receive significant fines, but have the means to leave the industry may walk away as an alternative to paying fines.
Cole-Frieman & Mallon LLP provides legal advice and support to all types of investment managers. If you have a question regarding any industry SRO, please feel fre to contact us directly. Bart Mallon can be reached directly at 415-868-5345.