FINRA and The Expansion of Nongovernmental Regulation

Friday, May 11th, 2012 at 11:32 pm, by Nick Petts

In March, it was reported that the Financial Industry Regulatory Authority (FINRA), the private nonprofit organization that regulates broker-dealers under the supervision of the Securities and Exchange Commission (SEC), saw a 50% spike in the fines it imposed over the past year.  This statistic highlights the importance of last October’s Fiero Brothers v. FINRA, Inc., in which the Second Circuit held that the Wall Street watchdog lacks the power to seek judicial enforcement of the fines it imposes on members for securities violations.  This disconnect between FINRA’s enforcement policies and legal authority may emerge in discussions around a new bill that will likely grant FINRA authority to oversee investment advisors, a delegation that could raise the same constitutional questions that hovered over the Fiero Brothers case.

The case arose out of disciplinary action FINRA took over a decade ago against a small brokerage firm, Fiero Brothers, Inc. (Fiero), for naked short selling.  In addition to expelling the firm, FINRA imposed a fine of $1 million, which Fiero refused to pay.  After wrangling in New York State court over a breach of contract claim, a lack of subject matter jurisdiction over securities law led the litigants to federal court, where Fiero sought a declaratory judgment that FINRA lacked authority to collect on the fine.  FINRA prevailed at the district court level, but on appeal, Judge Ralph K. Winter, Jr. found a lack of statutory authority for FINRA’s asserted power.  To be sure, FINRA would be able to expel member organizations and even impose fines, but the court found no clear congressional intent to delegate to FINRA the power to enforce those fines.  Moreover, although FINRA itself had issued in 1990 a regulation declaring a new policy to enforce fines, the Court found it to have been improperly promulgated, since it qualified as a legislative rule and thus required notice-and-comment rulemaking by the SEC.  The rule itself also struck the court as a bare assertion of authority, which had no independent source, such as a delegation by the SEC.

Assessments of the decision’s practical impact have been divided.  Columbia Law School’s John Coffee has said it will take the teeth out of FINRA at a time when it has tried to assume a tougher stance toward its members.  Yet some practitioners believe it will remain business as usual for the self-regulatory organization (SRO).  The Fiero case marks the first instance in FINRA’s seventy-year-plus history of it seeking judicial enforcement of a penalty.  The reason is that FINRA retains a disciplinary tool of even greater force – the ability to suspend or expel firms from the organization, membership in which is necessary to operate as a securities firm.  Unlike the one-man operation that was Fiero Brothers, no established financial institution – such as Goldman Sachs, which FINRA recently fined $22 million – can afford to refuse to pay up and be suspended or expelled by FINRA.  Thus, one commentator has noted that the only brokers which will be able to take advantage of the Fiero decision will be smaller firms.  Nonetheless, whether the decision will slow the consistent growth rate of FINRA’s enforcement actions and fines over the past several years remains to be seen.

The debate over FINRA’s enforcement power may soon come to the fore as proposed legislation is expected to further broaden the regulator’s mandate to include investment advisors.  On April 25, Representative Spencer Bachus, Chairman of the House Financial Services Committee, formally introduced a bill called the Investment Advisor Oversight Act of 2012.  The bill itself does not explicitly name FINRA as the new federal regulator for investment advisors, but most (including FINRA itself) expect FINRA to be the organization to receive that authority.  Federal regulation of investment advisors was previously within the SEC’s purview, but with the agency’s resources constrained significantly by the budget process, many have argued FINRA would be a more capable regulator.  Notwithstanding FINRA’s expertise, a substantial expansion of its regulatory and enforcement authority could draw attention to a lack of executive oversight of the organization.

The Supreme Court’s 2010 decision in Free Enterprise Fund v. PCAOB implicitly questioned the constitutional validity of private regulators beyond the President’s control, especially those, like FINRA, whose main function is enforcement, a paradigmatic executive power.  The Public Accounting Oversight Board (PCAOB) is a regulator which operates under the supervision of the SEC but whose board members at the time were removable by the SEC only for good cause.  The SEC’s commissioners, in turn, also have for-cause protection from removal by the President.  The Court held this structure of double for-cause protection unconstitutional because it renders the PCAOB members insufficiently accountable to the President, who has authority to supervise and guide executive officials in interpreting the statutes that federal administrative agencies implement.

Free Enterprise implies that there is a point at which nominally nongovernmental regulators acquire broad enough authority that they must be subject to the same kinds of procedural constraints that are required for administrative agencies.  In holding that double for-cause protection interfered with the Presidential directory authority, the Court recharacterized the PCAOB as in effect a government agency, based on the breadth of regulatory powers delegated to it by Congress.  To be sure, the PCAOB was not styled as an SRO like FINRA, but neither was it structured like a formal government agency.  Thus, while SRO’s like FINRA are private regulators beyond the scope of the constitution, Free Enterprise warns how fluid the SRO-agency divide can be.

In light of Free Enterprise, a sufficiently broad delegation of new authority to FINRA could trigger a similar constitutional issue regarding its own appointment and removal structure.  The directors on FINRA’s Board of Governors are elected by the securities industry and removable at will by a two-thirds vote of the board.  Even under FINRA’s current authority, many industry participants perceive an absence of accountability.  The U.S. Chamber of Commerce, for one, has recently criticized FINRA for its continued lack of transparency, which the trade organization attributes to the regulator’s not being subject to the Freedom of Information Act (FOIA) or the Administrative Procedure Act (APA), procedural statutes that control how most federal agencies operate.  Going forward, the issue is whether delegating FINRA new authority to oversee investment advisors will make the regulator appear enough like a government agency that its current lack of executive oversight will run afoul of Free Enterprise, especially if Congress grants FINRA the full enforcement power it was denied in Fiero Brothers.