Written by Ryan Adams and Christopher Haner*
In the wake of the financial crisis of 2008, many commentators called for increased regulatory oversight on behalf of the Securities Exchange Commission ("SEC") and the Financial Industry Regulatory Authority ("FINRA"). Despite a growing public movement for increased oversight, FINRA has been legally hampered in its ability to enforce its own rules. Recently, in Fiero v. Financial Industry Regulatory Authority, Inc., the Second Circuit Court of Appeals reversed and vacated a district court opinion that authorized FINRA to enforce fines that it had imposed against industry members. In what has been described as a surprising decision, the Court of Appeals held that FINRA lacked the authority to bring federal court actions to collect disciplinary fines it has imposed. The opinion, written by Circuit Judge Winter, held that FINRA cannot enforce monetary sanctions in court under either federal securities laws or as an internal "house-keeping" rule.
The underlying facts of Fiero are unremarkable. Fiero Brothers, a New York corporation and FINRA member firm, and its owner, John Fiero, were investigated by the National Association of Securities Dealers ("NASD"), FINRA's predecessor, in 1998 for naked short selling. On December 6, 2000, NASD held that Fiero violated Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), SEC Rule 10b-5, and FINRA Conduct Rules 2110, 2120, and 3370. Fiero and his firm's FINRA membership were revoked, and Fiero was barred from associating with any FINRA-member firm going forward. In addition, Fiero and his firm were fined $1,000,000 plus costs, jointly and severally.
The effect of a bar from associating with FINRA-member firms is tremendous. FINRA is a self-regulatory organization ("SRO") and the largest regulator of securities firms in the United States. All securities firms doing business with the public must not only be members of FINRA, but must abide by its rules. If FINRA determines that one of its member firms and/or their associated member representatives are not in compliance with federal securities laws and regulations, it will take appropriate disciplinary action against such wrongdoer. Thus, it performs a crucial role in the healthy functioning of our economy and seeks to prevent abuses in the securities market.
Traditionally, FINRA fines on perpetrators of fraud like Fiero, have been sometimes hard to collect. In the case at hand, Fiero refused to pay, and on December 22, 2003, FINRA commenced an action in New York Supreme Court. The court held that FINRA's claim was based on "ordinary principles of contract law" because Fiero had "expressly agreed to comply with all NASD rules including the imposition of fines and sanctions." The First Department of the New York Appellate Division affirmed this decision, but the New York Court of Appeals reversed on February 7, 2008, on the grounds that state courts lacked subject matter jurisdiction. The court held that the FINRA complaint constituted an action to enforce a duty within the Exchange Act, and therefore, fell within the exclusive jurisdiction of the federal courts.
On February 8, 2008, Fiero filed an action in the Southern District of New York seeking a declaratory judgment that FINRA lacked the authority to bring court actions to collect disciplinary fines. FINRA counterclaimed, seeking to enforce the fines levied against the Fieros under a breach of contract theory. Both parties moved to dismiss, and on March 30, 2009, the court granted FINRA's motion to dismiss and denied Fieros' motion, awarding judgment in favor of FINRA.
On appeal to the Second Circuit, Fiero argued that FINRA lacks authority to bring judicial actions to collect monetary sanctions. FINRA argued that it had proper authority under both (i) the Exchange Act, and (ii) a 1990 FINRA rule. The Court addressed each argument, holding (i) the Exchange Act did not properly grant FINRA authority, and (ii) the 1990 rule was improperly promulgated. The court therefore reversed the dismissal of the complaint and vacated the money judgment on FINRA's counterclaim.
In rejecting FINRA's authority under the Exchange Act, the Court looked to Section 15A(b), which provides that SROs like FINRA have statutory authority and an obligation to "appropriately discipline their members for a violation: of any provision of the Exchange Act; the rules or regulations promulgated thereunder; or their own rules; by expulsion, suspension, limitation of activities, functions, and operations, fine, censure, being suspended or barred from being associated with a member, or any other fitting sanction." Finding a lack of express statutory authority to bring judicial actions to enforce the collection of fines, the Court looked to congressional intent. The Court noted that the "statutory scheme carefully particularizes an array of available remedies, including permissible actions in the federal courts," but it does not expressly provide a judicial action. Based on a further analysis of congressional intent, the Court held that FINRA lacked authority under the Exchange Act.
FINRA also argued that it had proper authority under a 1990 amendment to its rules, which authorized the "collection of any fine in sales practice cases . . . ." The Court held that this rule was improperly promulgated pursuant to Section 19(b) of the Exchange Act, which establishes the process by which SROs can alter their internal rules. Under this section a formal "notice and comment" period is required, unless the rule is a simple "house-keeping" change which does not "substantially affect the public interest or the protection of investors." While FINRA had characterized the 1990 Rule as a "house-keeping" rule, the Court thought otherwise, and held that because it was a "new substantive rule" it was "never properly promulgated and cannot authorize FINRA to judicially enforce the collection of its disciplinary fines" because the rule was never properly filed.
Thus, while the Court noted in footnote 10 that it "of course intimates no opinion on the validity of a properly promulgated rule authorizing fine collection through judicial proceedings," FINRA is now effectively barred from enforcing monetary sanctions in court.
While the practical effects of this case are yet to be seen, it may serve to frustrate the administrative functioning of the FINRA appeals process. The Court, explaining this administrative appeals process, noted:
After a complaint is filed [with FINRA], a hearing panel conducts a hearing and issues a decision. Final decisions of the hearing panel may be appealed to the FINRA National Adjudicatory Council ("NAC"), which may affirm, modify, or reverse the hearing panel's decision. NAC decisions may then be appealed to the SEC . . . and from the SEC to the United States Court of Appeals.
Going forward, this case is likely to encourage broker-dealers to appeal an unfavorable decision, which imposes fines, to the NAC to see if the hearing panel's decision will be overturned. If the broker-dealer is unsuccessful in such an appeal, he is discouraged from appealing further because the SEC, unlike FINRA, can enforce the imposition of fines through court action.
While FINRA has lost power in its regulatory arsenal, it still has the power to revoke a broker-dealer's license for not paying fines. Because of FINRA's omnipresence in the industry, this provides a significant incentive to firms to comply. The Second Circuit even acknowledged this power, writing that, "FINRA fines are already enforced by a draconian sanction not involving court action. One cannot deal in securities with the public without being a member of FINRA. When a member fails to pay a fine levied by FINRA, FINRA can revoke the member's registration, resulting in exclusion from the industry." Significantly indicative of the Court's stance on FINRA regulations, the Court noted that the ability of a regulatory agency to exclude fraudulent merchants is a "draconian" power.
Note must be taken, however, that member firms and their associated representatives tend to be savvy business persons with a firm grasp on cost-benefit analyses. If the disciplined firm or representative determines that the cost of paying such a fine outweighs the benefit of being able to practice in the U.S. public securities market, due to an unsuccessful career, practice, impending retirement, or otherwise, the firm or representative is likely to ignore the fine and elect license revocation. We must be wary of firms or representatives that would rather lose their license than pay a heavy fine. Despite the revocation of their license, and the bar on their ability to do business in the public securities field, they may be able to keep their ill gotten gains, and this is plainly wrong and unjust.
For the text of the full decision, see:
 No. 09-1556-CV, 2011 WL 4582436, at *1 (2d Cir. Oct. 5, 2011).
 See Diana B. Henriques, Court Says Regulator Exceeded Its Power, N.Y. TIMES, Oct. 6, 2011, at B1, available at http://www.nytimes.com/2011/10/06/business/court-rules-against-finra-on-enforcement-actions.html.
 2011 WL 4582436, at *25.
 Id. at *5.
 Id. at *6.
 Id. at *11.
 Id. at *11.
 Id. at *21.
 Id. at *23.
 Id. at *24.
 Id. at *23.
 Id. at *27.
 Id. at *22 n.10.
 Id. at *4.
 Id. at *17.
 Id. at *17.
*Ryan Adams and Christopher Haner are third year law students at St. John's University School of Law. Both are student interns in the St. John's Securities Arbitration Clinic, a non-profit offering legal assistance to underserved investors.