Second Circuit Holds That FINRA Cannot Use The Courts To Collect Disciplinary Fines

Introduction

October 5, 2011, in Fiero v. FINRA, No. 09-1556-cv (2d Cir. Oct. 5, 2011), the United States Court of Appeals for the Second Circuit held that FINRA and other self-regulatory organizations lack the authority to bring federal court actions to collect on their disciplinary fines. The decision leaves in its wake an apparent gap in FINRA's enforcement arsenal; it can levy fines, but it cannot enforce collection of those fines in court. Although the import of this revelation might seem considerable at first glance, the true consequence of this decision is likely to be felt primarily in a narrow, yet important, swath of FINRA disciplinary matters.

FINRA¹ has long maintained the view, rooted in a 1990 rule filing and an associated Notice to Members (the "1990 Rule"), that it has the authority to seek judicial enforcement of its disciplinary fines. Although FINRA contended to its membership that it held such power, it generally did not seek to utilize that power to collect fines. In Fiero, as part of a long-running feud with one of its former members, FINRA deviated from its standard practice and sought enforcement of a disciplinary fine in both state and federal court. As discussed below, the results represent a resounding blow to FINRA's collection efforts.

Procedural Posture

In December 2000, a FINRA Hearing Panel found that Fiero Brothers, a registered broker-dealer, and John J. Fiero, its sole registered representative (together, the "Fieros"), violated the antifraud provisions of the Securities Exchange Act of 1934 ("Exchange Act") as well as certain FINRA Conduct Rules. The hearing panel expelled Fiero Brothers, barred Mr. Fiero from associating with any FINRA member firm, and imposed a fine of $1,000,000 plus costs on the Fieros, jointly and severally. The National Adjudicatory Council ("NAC") affirmed the hearing panel's decision and the Fieros did not appeal the NAC's decision to the SEC.² Subsequently, however, the Fieros refused to pay the fine, so FINRA brought an action in state court seeking to collect. Ultimately, the New York Court of Appeals ruled that FINRA's complaint constituted an action to enforce a liability created under the Exchange Act, which is within the exclusive jurisdiction of the federal courts. Therefore, the action was dismissed for lack of subject matter jurisdiction. See FINRA v. Fiero, 882 N.E.2d 879 (N.Y. 2008).

The Fieros then sought a declaratory judgment in federal court that FINRA lacks authority to collect fines through the judicial process. FINRA counterclaimed, seeking to enforce the fine based on a breach of contract theory. The District Court sided with FINRA, dismissing the Fieros' action for declaratory judgment and entering a judgment in favor of FINRA's counterclaim.

The Second Circuit Holds that FINRA Cannot Avail Itself of Judicial Enforcement

In reversing the District Court, the Second Circuit first addressed the question of whether the Exchange Act provides FINRA with the necessary authority. Section 15A(b) of the Exchange Act grants SROs the statutory authority to discipline their members and associated persons for violations of the Exchange Act, the rules promulgated thereunder, or their own rules. The court, however, found "no express statutory authority for SROs to bring judicial actions to enforce the collection of fines."³ Similarly, the court found no persuasive evidence of congressional intent to authorize such actions. While the federal securities laws provide an array of available remedies, including permissible actions in federal courts by the SEC, aggrieved parties, and private litigants, there is no reference to judicial enforcement of SRO sanctions in the Exchange Act, the Sarbanes-Oxley Act of 2002, or the Dodd-Frank Wall Street Reform and Consumer Protection Act. The court also refused to infer congressional intent from the aforementioned "seemingly inexplicable" gap in FINRA's enforcement scheme that would result from finding that SROs lack the authority to enforce fines in court — i.e., fines may be levied but not collected. According to the court:

The opinion does not address the broader implication of its holding in cases, such as Fiero, where the member and/or associated person is already expelled, and thus has limited incentive to pay the assessed fine.

After concluding that Congress did not intend to empower FINRA to bring court actions to enforce its fines, the court turned to the 1990 Rule pursuant to which FINRA notified the public of its presumed ability to bring court actions to collect fines. FINRA treated the 1990 Rule as a "house-keeping" rule because, in its view, instead of being a new rule, it merely constituted a stated policy with respect to the enforcement of an existing rule. As a "house-keeping" rule, the 1990 Rule was effective upon filing with the SEC and did not go through the notice and comment period or obtain SEC approval, as would be required for substantive rule changes. The court, however, disagreed with FINRA's characterization of the 1990 Rule. As discussed above, the court had already found that there was no existing statute or regulation that authorized SROs to initiate judicial proceedings to enforce the collection of disciplinary fines. Thus, in the court's view, the 1990 Rule represented a substantive rule change that affected the rights of barred and suspended members. As a result, the court held that the 1990 Rule, which was not subject to the requisite notice and comment process, was never properly promulgated and therefore cannot serve to authorize FINRA to judicially enforce the collection of its disciplinary fines.⁵

What is the Impact on FINRA's Enforcement Program?

The Second Circuit's ruling is likely to have a significant impact on a relatively narrow group of firms and individuals. Clearly, respondents who have been subjected to permanent bars or lengthy suspensions such that future employment in the securities industry is unlikely now have even less incentive to pay any fines levied against them. In addition, for members and associated persons embroiled in high-stakes enforcement investigations, the ruling may impact the calculus in terms of whether to settle or litigate with FINRA or whether to appeal disciplinary sanctions to the SEC (which claims authority to seek judicial enforcement of sanctions where it has affirmed an SRO order). For most FINRA members and associated persons, however, the threat of expulsion from the industry remains a "draconian sanction" sufficient enough to incentivize compliance with any disciplinary sanction. In addition, on a programmatic level, the Second Circuit's opinion is not likely to have a major impact on the manner in which FINRA conducts enforcement investigations or pursues disciplinary sanctions.

The Fiero decision also serves as a warning to FINRA to be mindful of the requirements for proposing and adopting new rules. Respondents rarely challenge the sufficiency of the rulemaking process that promulgated the rules at issue in a given matter. This decision, however, may embolden respondents to take aim at the adequacy of the rulemaking process for certain rules, especially in instances where a core component of FINRA's case relies upon "house-keeping" rules. It remains to be seen whether FINRA attempts to cure the 1990 Rule, or perhaps seeks to preemptively shield other "house-keeping" rules, by availing itself of the formal rulemaking process applicable to substantive rule changes.

Footnotes

1 Although the party at the time of the prior court proceedings was the NASD, the Second Circuit decision refers to the relevant party by its current name, FINRA, which came into existence in July 2007 after the merger of the NASD with parts of the regulatory program of the NYSE. For ease of reference, we refer to the relevant party as FINRA throughout this article.

2 The SEC takes the position that it has the authority to bring an action in federal district court to enforce any order it issues affirming sanctions imposed by SROs.

3 Fiero v. FINRA, No. 09-1556-cv, slip op. at 9 (2d Cir. Oct. 5, 2011).

4 Id. at 13.

5 The Second Circuit offered no opinion "on the validity of a properly promulgated rule authorizing fine collection through judicial proceedings." Id. at 17 n.10.

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