A case broiling in federal appeals court between FINRA and a Salt Lake City-based brokerage firm is a potential “headshot” for the regulator, according to several securities attorneys and legal scholars watching the proceedings.
An unfavorable decision against FINRA could, at a minimum, undercut the authority of Wall Street’s self-appointed sheriff, these scholars say. While that may seem hyperbolic, they point to recent court decisions, including those issued by the U.S. Supreme Court, that increasingly call into question the constitutionality of self-regulatory organizations, industry-run watchdogs that wield legal judgements, and hold enforcement power, over individuals and businesses. Those decisions are beginning to chip away at the foundation upon which FINRA operates.
“Ten years ago, these arguments were frivolous,” said James Tierney, a professor at the Chicago-Kent College of Law. “But the Supreme Court has made enough room for (them) to take hold.”
The current front on the war against FINRA is a case brought by Alpine Securities, a brokerage firm with a long history of regulatory skirmishes.
In August 2019, FINRA charged Alpine with mishandling client funds, conducting unauthorized trades and charging unreasonable fees. Alpine tried to argue its due process rights were violated by FINRA’s use of virtual arbitration hearings, but in March 2022, a FINRA hearing panel expelled Alpine from the industry, forbidding it from doing business and ordered it to pay $2.3 million in restitution. Later, FINRA moved to expedite the expulsion, arguing Alpine was defying a cease-and-desist order.
Alpine challenged that decision in court, and volleyed back with a lawsuit of its own, filed in Florida federal court (later transferred to Washington, D.C.) challenging the regulator’s legal foundation.
The firm won a small victory last month when a three-judge panel agreed to halt the FINRA ban, citing Alpine’s substantive legal challenge to the regulator.
“Alpine has raised a serious argument that FINRA impermissibly exercises significant executive power,” wrote Circuit Judge Justin Walker in that decision.
That argument goes like this: FINRA’s “hearing officers,” those individuals who head the arbitration panels that rule on cases between FINRA’s enforcement division and its member firms, are essentially judges; they run the “trials,” rule on admissibility of evidence, issue judgements and, in the end, oversee enforcement of U.S. securities laws and levy punishments, even deciding whether a business can continue operating at all. Yet these individuals, vetted and hired by FINRA itself, are, by FINRA’s own rules, independent operators. They are not accountable to anyone in the hierarchies of government. That violates the Constitution, Alpine’s lawyers argue.
Tierney, a former in-house attorney for the SEC, told WealthManagement.com the D.C. Circuit has long taken a skeptical attitude toward FINRA’s enforcement powers, and has likened its ability to ban people and businesses as a kind of “corporate capital punishment.”
A favorable decision for the brokerage firm worries Ben Edwards, a professor at the William S. Boyd School of Law at the University of Nevada, Las Vegas, who’s been following Alpine’s dual cases against FINRA. He thinks a victory for Alpine could pose a “systemic risk” to modern financial markets, which could be thrown into turmoil under a toothless watchdog and an underfunded Securities and Exchange Commission—under whose purview FINRA operates—unable to take up the slack.
“I think the case has a shot,” he said. “But if they win, the consequences could be terrible.”
In July, FINRA filed a motion to have the Circuit Court’s decision overturned, saying Alpine’s argument relied on legal theories that “every court” had previously rejected, and that “FINRA is not a state actor subject to the Constitution’s rules on appointments.”
If FINRA’s hearing officers are subject to the Constitution, that “would effectively decapitate FINRA’s enforcement program” and “destroy the self-regulatory model that has served the securities industry and investors so well for decades,” the motion reads.
Alpine owner John Hurry is no stranger to regulatory fights. FINRA tried to bar him from the industry in 2017 for Alpine’s alleged unregistered sale of microchip securities, a decision that was later overturned by the SEC. Last year, the SEC charged the brokerage firm and two of its employees with unauthorized securities transactions.
Miranda Fritz, a New York-based attorney who is part of the team representing Alpine Securities, told WealthManagement.com the firm was the subject of “unbelievably aggressive action” from FINRA, primarily because it focuses on the microcap sector of the market, an area the regulator considers “rife with fraud,” according to Fritz.
As she has represented Alpine in the skirmishes against FINRA, she said her view on the self-regulator darkened.
“The fact that they do not feel they have to abide by the Constitution, that if you mention the words due process to them, the response is ‘we are not a state actor,’ it initially shocked me,” she said. “And then I began to see the countless ways that the ability to just ignore the Constitution has all kinds of impacts on the way they can go after folks in the industry.”
Smaller brokerage firms have long criticized FINRA for treating them unfairly, making examples out of less prominent firms to demonstrate their regulatory zeal, while taking a softer, more collaborative approach with larger firms.
But Edwards and Tierney argue the Alpine dispute is the latest case affected by a more conservative Supreme Court with “an aggressive anti-administrative state agenda.”
Alpine’s lawyers point to the Supreme Court decision in 2018’s Lucia v. SEC, in which justices ruled against the commission on the grounds its appointment of administrative law judges—essentially judges that oversee hearings and can make decisions determining whether sanctions are warranted— violates the Constitution’s appointments and removal clause.
In this year’s Axon Enterprise v. FTC and Cochran v. SEC, the Court concluded that individuals who believe an agency rule or decision violates their rights can sue that agency even before the agency makes its own assessment of the rules.
In a law review article, Edwards pointed to the 2010 Supreme Court case Free Enterprise Fund v. Public Co. Accounting Oversight Board (PCAOB) as another example of changes in thinking at the Supreme Court level. Though created by Congress, the PCAOB’s structure is similar to self-regulatory organizations like FINRA.
A D.C. Circuit Court judge wrote in that case that the PCAOB violated the separation of powers principles and “the appointments clause” in the Constitution. While the Supreme Court’s majority decision did not agree on that latter point, the author of that opinion was Judge Brett Kavanaugh, who now sits on the Supreme Court.
“Today’s court is different,” Edwards said. “There’s a real risk for an SRO (self-regulatory organization) before the current Supreme Court.”
Edwards said the ramifications of a decision against FINRA are a potential “risk to the financial system.” If a ruling cut the legs out from SROs like FINRA, he asked, what would happen to the financial services industry or to investors’ ability to trade?
“Courts are not ordinarily well equipped to understand the market consequences of their rulings, so there’s a risk here that a court may enter an order thinking the market will figure it out, but not understand the consequences for that process,” Edwards said. “You might need congressional action to put things back on track, and that might take weeks.”
Consequences of the case would depend on the scope of the ruling, but if the court went as far as to say Congress and the SEC couldn’t delegate policy decisions to FINRA, it could throw the industry into turmoil.
“I don’t want to be Chicken Little, but there would be a great amount of disruption in settled practices in capital markets,” Tierney said.
Even if there were a more limited ruling that kept FINRA intact but reduced its powers, Tierney suspects there would be less enforcement because their ability to investigate and rule on the facts would be limited.
The SEC wouldn’t likely bring those cases in-house without a boost in resources approved by Congress, and that is unlikely, he said.
“If it turns out that FINRA has lost its enforcement power, and states don’t have enough funding, and an overstretched SEC couldn’t do anything, the dam could break after a few years,” he said.
Though the legal battle engulfing Alpine Securities and FINRA could span years, the impact will likely be felt sooner. It opens the doors for other firms to make a similar defense, potentially halting more FINRA enforcement decisions, says Sander Ressler, a managing director of Essential Edge Compliance Outsourcing Services.
“That puts the public in jeopardy,” he said. “We want to root out the bad actors, but if they’re going to raise this defense, it could put bad actors in a place where they can continue their bad acts without regulatory intervention.”
To Fritz, the PCAOB decision could serve as a “roadmap” for how FINRA might adapt if the court rules against the regulator, and she says it is not an impossible task, nor would it have to wreak havoc on the financial system.
“The sky did not fall when Lucia was decided or PCAOB,” she said. “It’s entirely doable for them to actually abide by the Constitution as they … try to deprive people of their businesses or livelihood.”