Keywords: FINRA, collect fines, members, disciplinary proceedings, NASD, Exchange Act
On October 5, 2011, the US Court of Appeals for the Second Circuit held in Fiero Brothers v. FINRA, Inc, 09-Civ.-1556; 09-1863 (2d Cir. 2011) that the Financial Industry Regulatory Authority (FINRA) lacks the power to sue to collect the fines it imposes against its members in disciplinary proceedings.
In 1998, FINRA's predecessor, the National Association of Securities Dealers (NASD) expelled Fiero Brothers and imposed a fine of $1 million plus costs for (among other charges) violating Section 10(b) of the Exchange Act and Rule 10b-5. Fiero refused to pay the fine and FINRA commenced an action in New York Supreme Court to collect the funds. This was the first time FINRA ever attempted to judicially enforce a fine.
Both the trial court and Appellate Division found for FINRA, but the New York Court of Appeals reversed the decision for lack of subject matter jurisdiction, concluding that FINRA's complaint was subject to exclusive federal jurisdiction under the Exchange Act. Immediately following the Court of Appeals decision, Fiero Brothers commenced an action in federal court seeking a declaratory judgment that FINRA has no authority to seek judicial enforcement of the fine; FINRA counterclaimed seeking payment of the fine under a breach of contract theory. The District Court for the Southern District of New York (Victor Marrero, J.) found for FINRA.
The Second Circuit reversed. The Court considered two sources of authority that FINRA argued gave it the power to judicially enforce its fines: The Exchange Act, and a proposed rule change that FINRA submitted to the SEC in 1990. The Court concluded that while the Exchange Act allowed FINRA to "appropriately discipline" member firms using such means as expulsion, suspension, fines or censures, the Act did not expressly grant FINRA the power to commence collection actions.
Contrasting the Exchange Act's express grant of authority to the SEC to bring suit to implement its penalties, the Court found that Congress knew how to grant an agency access to the courts, and did not do so for FINRA. This suggests that Congress did not intend to impliedly grant FINRA the authority to use the courts to enforce fines. The Second Circuit also noted that 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 bring suit to enforce its penalties, Congress would have provided for that possibility, rather than leaving a self-regulatory organization (SRO) to commence common law proceedings. Further, Congress's grant of exclusive jurisdiction to the federal courts for Exchange Act enforcement proceedings was inconsistent with an intent to permit actions under state common-law theories. The Court also explained that FINRA is not without coercive power—if a firm does not pay its fine, FINRA can unilaterally expel or suspend a member, excluding it from the securities industry.
With respect to the rule change, NASD had in 1990 filed a proposed rule change with the SEC and notified members that the NASD would pursue "other means" for the collection of fines, including seeking to have fines reduced to judgment. FINRA argued that this proposed rule change also provided FINRA with the authority to judicially enforce its fines. Not persuaded, the Second Circuit concluded that when the NASD notified its members in 1990 that it would initiate lawsuits to collect fines, the NASD was simply assuming the existence of a preexisting power that it did not have.
Further, according to the Court, the notice of proposed rule change could not have acted as a prospective authorization to exercise such a power because it was procedurally improper. An SRO must ordinarily file a proposed rule change with the SEC, accompanied by a general statement of the basis and purpose of the proposed rule. The SEC must then make the proposed rule subject to a notice and comment period before it takes effect. There is an exception to the notice and comment period for "house-keeping" rules, which do not substantially affect the public interest or protection of investors. Despite FINRA's protests, the Second Circuit found that the proposed rule was not a house-keeping rule, and was subject to the notice and comment period—which it did not receive.
This ruling no doubt is disappointing to FINRA. However, it seems unlikely to have an impact on larger institutions. No significant financial institution can risk being suspended or expelled by FINRA, and, as the Second Circuit made clear, FINRA can still use that threat to enforce its penalties. The impact will likely be more significant on smaller broker-dealers that may elect to give up FINRA membership rather than pay a ruinous penalty. The ruling also would seem to make fines and expulsion exclusive options—once a member has been expelled, FINRA has no further threat to compel payment of a fine. Given that Fiero Brothers was the only time FINRA ever sought court action to enforce a fine, it will be interesting to see if FINRA seeks certiorari or applies to the SEC for express authority to commence enforcement actions in court.
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