Law360 (November 1, 2023) By Dan Shaw
An embattled brokerage firm has its knives out against FINRA in a court case that the industry self-regulator warns poses an "existential threat" to a compliance system that has served investors well for decades.
The Financial Industry Regulatory Authority, a private entity deputized by the Securities and Exchange Commission to regulate brokerage firms, filed a brief on Oct. 27 talking of a possible threat to its existence should it fail in a legal battle now being waged in federal appeals court in Washington, D.C. That fight pits it against Salt Lake City-based Alpine Securities, a clearing and brokerage firm that's been under a FINRA expulsion order since March 2022, when it was found by the regulator to have saddled customers with unreasonable fees and other expenses.
At the heart of Alpine's arguments are questions about whether it's constitutional to allow a private organization to police large swaths of the securities industry. FINRA, through authority delegated to it by the SEC, oversees roughly 620,000 registered representatives at nearly 3,500 firms.
Alpine, a firm with a long history of run-ins with regulators, argues that FINRA can be only one of two things under the U.S. Constitution: Either it's a private company with severely restricted ability to regulate the brokerage industry, or it's more of a public state actor whose enforcement officers are subject ! to direct appointment by the federal executive branch.
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But it can't — so the plaintiffs contend — be both. Yet, the legal complaints argue, FINRA has increasingly straddled the line between a public enforcement agency and a private industry group ever since its founding in 2007.
In a legal complaint filed on Oct. 12, Alpine Securities and its affiliate Scottsdale Capital Advisors contend that FINRA "deploys its broad powers to impose burdensome, arbitrary, and ill-defined standards that it requires its members to follow, and it enforces those standards in an arbitrary, discriminatory, and unfair manner, all of which ultimately harms the investing public."
Maranda Fritz, a lawyer representing Alpine Securities, said in an email that "F INRA's position would enable any governmental agency to outsource governmental power to a purportedly private entity and thereby avoid any need to afford regulated individuals and entities the protections contained in the Constitution."
Arguments similar to Alpine's appear in separate legal challenges filed by two other brokers faced with the threat of FINRA disciplinary measures. On Aug. 8, Eugene H. Kim, a registered advisor and broker under investigation for allegedly misleading investors in a private placement scheme, filed a suit also questioning FINRA's basic constitutionality. That was followed on Oct. 18 with more arguments of the same kind in yet another legal action, this one from Sidney Lebental, a former broker under investigation for allegedly running a Treasury bond scam.
All of these challenges come at a time when the U.S. judicial system has ! been loo king with increasing skepticism at the executive branch's ability to delegate police powers to other agencies. A case now before the Supreme Court raises many of the same constitutional questions about the SEC's reliance on in-house adjudicators known as administrative law judges, or ALJs.
In Jarkesy v. the SEC, the SEC is questioning an appellate judge's decision to vacate an order calling for a hedge fund manager named George Jarkesy to pay almost $1 million for alleged securities violations. Jarkesy won his appeal by arguing that the ALJ who had previously heard his case had exercised unconstitutional authority.
Among other things, Jarkesy cast doubt on the SEC's reliance on an internally selected board for making decisions about when ALJs should be removed from office. That system, Jarkesy and his lawyers maintained, unconstitutionally shielded in-house judges from direct removal by the U.S. president.
Alpine, Kim and Lebental all rely on similar arguments in their suits against FINRA. Alpine, for instance, contends that, "Despite its vast authority and the far-reaching consequences of its actions, FINRA is immune from the supervision and control of the President. "
James Tierney, an assistant professor of law at Chicago-Kent College of Law, said he would have had a hard time believing five or 10 years ago that arguments of this type could gain much traction in the judicial system. But courts have since shown to be more receptive to challenges on such constitutional grounds.
"That's probably not great for FINRA, as far as them being able to rely on business as usual," he said.
Tierney said he doubts any court decision could lead to the abolishment of FINRA. The worst outcome he could imagine, from the agency's perspective, is that the judges rule in a way that essentially "neuters" its enforcement abilities.
"Then you'd have to have someone else, possibly the SEC or state regulators, pick up the slack," Tierney said.
Former Attorney General William Barr, who served in the Trump administration, has waded into the controversy on the side of the FINRA opponents. In a friend-of-the-court brief filed on Sept. 5, he and former U.S. Solicitor General Noel Francisco argued that "because FINRA wields an astonishing amount of executive power without adequate control or accountability, it violates the Constitution no matter which analysis the Court applies."
The brief was filed on the behalf of the American Free Enterprise Chamber of Commerce, a group formed to fight the "insatiable expansion of the federal regulatory state." The U.S. Department of Justice, meanwhile, has joined FINRA in seeking to uphold the self-regulator's authority over the brokerage industry.
Firing back in its brief dated Oct. 27, FINRA argued that self-regulation in the U.S. securities industry dates to the founding of the Philadelphia Stock Exchange in 1790. The system, it contended, was further affirmed when Congress passed the Securities Exchange Act of 1934 and let "private self-regulatory organizations continue to exercise a primary supervisory role over their members, subject to comprehensive SEC oversight."
FINRA also cites a recent case involving Nasdaq, a self-regulatory stock exchange. In a decision handed down on Oct. 18, the Fifth Circuit Court of Appeals found that Nasdaq cannot be the subject of constitutional lawsuits seeking to challenge a rule requiring diversity on its board of directors.
FINRA's brief further maintains that it is subject to substantial SEC exercises oversight. FINRA, for instance, must submit all of its proposed rule changes to the SEC for approval and must enforce not only its own compliance and conduct standards but also the commission's as well.
"In sum, Alpine's arguments would eviscerate the self-regulatory framework that has served investors so well for centuries, replace private oversight with federal regulation, and inject the Constitution into broad swaths of the private economy," FINRA's brief concluded.
Alpine's case against FIN! RA was initially filed in October 2022 in federal court in Florida and later moved to Washington D.C. The action came in response to FINRA's attempt to have its expulsion of Alpine expedited after investigators accused the firm of breaching a separate order to cease overcharging customers.
Alpine — whose affiliate Scottsdale Capital Advisors previously succeeded in having a FINRA order overturned — was defeated in its constitutional challenge of FINRA at the federal district court in Washington, D.C. but then went on to file an appeal. That led to a panel of judges on the D.C. federal circuit court issuing an emergency order on July 5 preventing FIN RA from carrying out an expedited expulsion of Alpine.
Significantly, the three-member judicial panel found that Alpine was likely to win with its argument that FINRA officials were unconstitutionally exercising executive authority. One of the judges, Circuit Judge Justin Walker, wrote in a concurring opinion that FINRA hearing officers are "near carbon copies" of the SEC ALJs also now under scrutiny.
With its latest brief, FINRA takes its cases to the full Ninth Circuit Court of Appeals. Alpine is scheduled to file a reply by Nov. 17.
Tino Lisella, a securities litigation and enforcement lawyer in the West Palm Beach, Florida, office of Carlton Fields, said FINRA does appear to house a lot of different types of authority under one roof. That could give rise at least to perceptions of a conflict of interest.
"If you end up at a FINRA enforcement proceeding, you are now in front of a hearing officer who is hired by FINRA and paid by FINRA," Lisella said. "Yes, they are independent. But they are still employees of FINRA. And the first level of appeal is to the [National Adjudicatory Council], which is also a body within FINRA."
Lisella said it's of course hard to predict what the D.C. appeals court will do. If it does rule against FINRA, it may do so in a way that simply insists its hearing officers be subject to federal appointment. Or it could require more enforcement responsibilities to be handed directly by the SEC.
"Whether this results in a substantial defanging of FINRA really depends on to what extent the court is willing to pull the plug on all this," Lisella said.
Benjamin Edwards, a professor of law at the William S. Lloyd School of Law at University of Nevada-Las Vegas, said he hopes the court moves cautiously with whatever decision it hands down. Constitutional or not, he said, FINRA and other self-regulatory organizations like stock exchanges play a crucial role in maintaining the orderly function of capital markets.
Simply abolishing them or even greatly rolling back their authority would raise the risk of a "judicially created financial crisis," Edwards said.
Edwards predicted in a paper from 2022 that increasing skepticism toward federal regulators would most likely result in lawsuits challenging the constitutionality of self-regulatory organizations. So far, he said, courts have generally shown restraint in their willingness to roll back regulatory powers.
"They have not been throwing agencies out wholesale," Edwards said. "They have been pushing for changes in how particular enforcement actions are done. My hope is that if they do anything here, that they do it narrowly and carefully."