Litigation: Is FINRA still fine?

A recent 2nd Circuit decision could significantly impact small and medium size broker-dealer firms.

On Oct. 5, 2011, the 2nd Circuit held in Fiero Brothers v. FINRA that the Financial Industry Regulatory Authority (FINRA) lacks the power to sue its members to collect fines it imposes in disciplinary proceedings. The decision arose from FINRA’s suit against the Fiero Brothers securities firm to recover a $1,000,000 fine.

On Feb. 6, 1998, the National Association of Securities Dealers (NASD) initiated disciplinary proceedings against Fiero Brothers for violating Section 10(b) of the Exchange Act, Rule 10b-5, and FINRA Conduct rules. The NASD both expelled Fiero Brothers and fined it $1,000,000 plus costs. Fiero refused to pay the fine and FINRA commenced an action in New York Supreme Court to collect the funds.

The suit broached new ground—this was FINRA’s first attempt to judicially enforce a fine—more than 20 years after it believed it gave itself the power to do so. The Supreme Court held for FINRA, granting them the right to recoup the fine. The Appellate Division, First Department affirmed, but the New York Court of Appeals reversed for lack of subject matter jurisdiction.

The Court of Appeals held that FINRA’s complaint asked the court to enforce a duty under the Exchange Act that fell exclusively within federal jurisdiction. Immediately following the Court of Appeals’ decision, Fiero Brothers commenced a declaratory judgment action in federal court seeking an order that FINRA lacks authority to seek judicial enforcement of the fine.

The district court found in favor of FINRA, dismissing the Fiero Brothers’ claim, which the 2nd Circuit later reversed. Parsing the Exchange Act for signs of congressional intent empowering FINRA to sue to collect its fines, the court found that none existed. The Exchange Act only allowed FINRA to “appropriately discipline” member firms by a litany of punishments, including expulsion or suspensions, fines or censures, but it did not expressly provide for court action.

The court used this absence of authority to negatively infer congressional intent to leave FINRA powerless to judicially enforce its punishments.

But the 2nd Circuit predicated Fiero on more than negative implications. Disciplined FINRA members can appeal their punishments to the SEC and thereafter to the Court of Appeals. The court reasoned that, had Congress intended that FINRA use courts to enforce its fines, it would have said so. Further, Congress gave federal courts exclusive jurisdiction to enforce the Exchange Act.

FINRA’s breach of contract theory of recovery, which would often play out in state courts, undermines that exclusivity by calling on state courts to analyze and enforce Exchange Act provisions.

The court also dispensed with the argument that, if FINRA could not use the courts to recover fines, it lacked enforcement capabilities over its punishments. All securities firms must be a FINRA member to deal with the public.

If a firm does not pay its fine, FINRA can expel or suspend it, excluding it from the securities industry. And the court viewed FINRA’s longstanding practice of not using court action to recoup its fines as evidence that FINRA believed it lacked judicial enforcement power.

Finally, the court cast aside FINRA’s argument that a 1990 proposal to “pursue the collection of any fines” was a rule change that gave FINRA the power to judicially enforce its fines. To change a rule, an SRO ordinarily must file the change with the SEC accompanied by a general statement of the basis and purpose of the proposed rule. The SEC then makes the proposed rule subject to a notice and comment period before taking effect.

Although there is an exception to the notice and comment period for “house-keeping” rules—rules that do not substantially affect the public interest or protection of investors— the court found that the proposed rule was not a housekeeping rule because it was never subject to a notice and comment period.

Ultimately, the 2nd Circuit’s ruling is unlikely to have a major impact on large securities firms. Major institutions will pay their fine rather than risk suspension or expulsion by FINRA. UBS recently did just that, in response to $12 million for flawed supervision of short sales.

The interesting reaction to Fiero Brothers will come from medium and small broker-dealer firms who may elect to give up FINRA membership rather than pay a crippling fine.

Time will tell.

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Matthew Ingber

Matthew Ingber is a litigation partner at Mayer Brown.

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