Legal Threats to Wall Street’s Self-Regulators May Upend Markets

Looming circuit court rulings on the constitutionality of FINRA and other Wall Street self-regulatory groups have attorneys and law professors concerned about a potential shock to the American securities trading system if the bodies that police the market are rendered powerless.

The clashes over those self-regulatory organizations, some little known outside the financial industry, are playing out in the shadow of US Supreme Court cases over the power of government agencies. A ruling is expected soon in one of the agency cases, SEC v. Jarkesy, on the Securities and Exchange Commission’s use of in-house judges, known as administrative law judges.

“What’s interesting from an industry perspective is what happens with these SROs,” said Maxim Nowak of Herrick, Feinstein LLP in New York. “If Jarkesy curtails the SEC’s ability to use ALJs, SROs may be in trouble too,” he said. “The logic extends to them.”

But if broker-dealer and clearing firm Alpine Securities Corp. succeeds in its constitutional arguments against the non-governmental enforcement power of the Financial Industry Regulatory Authority, the Depository Trust and Clearing Corp., and two DTCC subsidiaries, the practical effects could be significant.

“In my view, the worst-case scenario is a judicially created financial crisis,” said Benjamin Edwards, a professor at the William S. Boyd School of Law at the University of Nevada, Las Vegas. Edwards submitted a friend of the court brief supporting FINRA in an Alpine case at the US Court of Appeals for the District of Columbia Circuit, which was argued in February.

Since then, the appeals court has asked for additional briefing. The action suggests it’s taking seriously the Salt Lake City-based firm’s challenge to FINRA’s role as a regulator of brokers, he said.

The case could go to the Supreme Court, he said.

Firm Fights Its Tormentors

FINRA pursued Alpine, once a major clearinghouse for penny-stock trades, for alleged misconduct related to customer accounts. The DTCC, meanwhile, said the firm lacked sufficient capital for clearing under new rules. Both organizations reached in-house decisions against Alpine—with FINRA expelling it from membership and the National Securities Clearing Corp., a DTCC subsidiary that oversees transaction clearing, refusing services.

Alpine challenged the SROs’ constitutionality in a pair of suits. Its first step was to ask the courts to stop the groups from putting Alpine out of business—imposing what it called the “corporate death penalty"—while the court cases proceeded. Its arguments fell flat in the US District Court for the District of Columbia against FINRA and—in the District of Utah—against the DTCC, the NSCC, and another related entity, the Depository Trust Co.

But an initial panel of D.C. Circuit judges sided with Alpine in granting a pause during the pendency of its appeal.

A slightly different three-judge panel at the D.C. Circuit heard arguments encompassing the constitutional merits of the challenge in February. At oral argument, the judges grappled with Alpine’s fate and the potential implications of a ruling in its favor.

The issue ultimately seems headed for the Supreme Court, Edwards said. A case reviewing FINRA sanctions is currently at the Fourth Circuit, creating a path for a potential circuit split.

Consequences

“The brokerage industry has been fighting for self-regulation since the 1980s,” said Adam Gana, managing partner of Gana Weinstein LLP, which represents investors in disputes with investment advisers and broker-dealers. “To now say it’s unconstitutional is laughable at best.”

If courts rule for Alpine, “the ramifications are beyond the scope of what I can imagine,” Gana said. “Every enforcement decision since 1988 is void? Barred brokers can rejoin?”

UNLV’s Edwards also said he’s concerned about “a potentially catastrophic outcome for American markets” if FINRA is declared unconstitutional. In his amicus brief, he argued that FINRA’s absence would render most brokerage activity unregistered and therefore illegal; favor institutional over retail investors, and take away other necessary infrastructure.

Nowak pointed to potential procedural burdens on regulators and the courts. “Are enforcers really going to be required to bring standalone actions in federal court every time there is an enforcement action?” he asked. “Will the enforcers and the courts be provided with the needed increased resources that change might require?”

But Marc Indeglia, a partner at Glaser Weil Fink Howard Jordan & Shapiro LLP in Century City, Calif., and president of the Small Public Company Coalition, says the potential effect on capital markets wouldn’t necessarily be negative. Securities enforcement “is like any other law enforcement,” sometimes in need of a “hard look.” A win for Alpine could provide “a level of due process that FINRA isn’t accustomed to offering,” or the president might need to appoint its hearing officers, he said.

The NSCC and DTC also have essential roles, attorneys say.

If Alpine’s suit removes enforcement powers from the NSCC and the DTC, “then who is going to actually be policing this?” asked Cornell University law professor Charles K. Whitehead, who specializes in corporate law and securities and financial regulation. “Well, presumably it’s going to be the SEC or some other regulatory body,” he said. “That’s a lot less efficient.”

The litigation “goes to the guts of the DTC system,” which is central to how securities transactions are settled, he said. If the organization can’t police participants in its system, “it raises real questions about the ability of DTC to continue to operate” as it has been, he said.

Alpine’s Attorney

But Maranda Fritz, a solo attorney for Alpine, says the DTC’s underlying action against her client “is part of a continuing effort by regulators, especially FINRA, to shut down the microcap markets.”

“These aggressive actions by regulators directed at the microcap markets cause real damage to the small and emerging companies that are a vital part of our economy because small companies need access to the markets to obtain financing and services,” Fritz said in an email.

“As is too often the case, the largest companies and the wealthiest continue to thrive while those with fewer resources are deprived of the ability to access capital,” the New York-based lawyer said.

Tea Leaves

The D.C. Circuit’s request for additional briefing offers a clue about what the court is grappling with.

“The provision the Court asked about allows the SEC to exempt brokerages from the mandatory requirement that they join a national securities association in order to trade,” Edwards said. If FINRA is “vaporized,” brokerages would be left without a required membership, and many would likely rush to get an exemption from the SEC, he said.

That focus “suggests the court may be considering how the SEC might manage if FINRA were declared unconstitutional,” Edwards said.

But the appeals court might simply be looking at the SEC’s ability to grant exemptions while it reviews FINRA expulsion actions, Edwards said. “It’s always hard to know what a court is thinking.”