Following a slew of significant corporate settlements over the last several months — none involving criminal charges being brought against corporations or individuals — federal regulators and law enforcement have heard an increasing outcry over the lack of criminal prosecutions of financial institutions and their executive leadership. Congress, irked by the perceived “Too Big to Jail” policy, recently summoned Attorney General Eric Holder to a hearing, where he defended the Department of Justice (DOJ) as being “appropriately aggressive” in its investigations, yet also voicing his concern that a prosecution of a large financial institution could have a “negative impact on the national economy.” (Click here to view the full transcript of Attorney General Holder's remarks.).

The media has feasted on the notion of a financial industry above oversight or investigation — the phrase “Too Big to Jail” returns more than 4,000 hits in a Google News search. News outlets have run programs furthering this perception. Recently “Frontline,” the investigative reporting program on PBS, ran a piece titled “The Untouchables,” which examined why Wall Street executives have avoided prosecution during the fallout from the financial crisis.

However, some commentators have recognized that criminal prosecutions may not be the best — or appropriate — outcome. Following Attorney General Holder’s appearance on Capitol Hill, Professor Peter Henning ran a post with the title “After Financial Crisis, Prosecutors Navigate Tricky Waters” on his informative White Collar Watch blog in The New York Times. Professor Henning, himself once with the DOJ and Securities and Exchange Commission (SEC), acknowledged a critical factor DOJ must consider before charging a corporation — whether the severe and swift collateral consequences would cause disproportionate harm to the public and shareholders (in the words of the DOJ manual, “others not proven personally culpable”) and outweigh the goals of a prosecution. Attorney General Holder and DOJ prosecutors are right to use the utmost caution in charging not only a financial institution but also any publicly traded institution, especially in cases where, as Attorney General Holder noted before Congress, DOJ identifies conduct that is “wrong” but does not rise to criminality.

Amid the public outcry over the lack of criminal prosecutions, one would hardly expect to hear general counsel at a financial institution describe the last several years as operating in an industry without regulation or investigation. In late 2009, President Obama announced the establishment of an interagency financial fraud enforcement task force, an effort DOJ trumpets as resulting in the filing of more than 10,000 financial fraud cases. Other regulators, such as the Office of the Comptroller of the Currency and the Federal Reserve Board, and the SEC, have also been active in their oversight, announcing large settlements with financial institutions. And in light of the ongoing congressional hearings and investigations, general counsel at financial institutions are right to expect continued and growing oversight and regulation.

While the media point out that financial institutions may be “too big to jail,” they certainly have not been “too big to investigate” or “too big to regulate.” But those aren’t catchy headlines. Nor are they true.

On October 5th, the United States Court of Appeals for the Second Circuit ruled that the Financial Industry Regulatory Authority (FINRA) does not have authority to bring lawsuits to collect fines imposed in disciplinary proceedings.  According to Diana B. Henriques of the New York Times, “The surprise decision curbs the power of [FINRA] … at a time when it has been under pressure to impose greater accountability on its licensed brokers and brokerage firms.”  The impact of the ruling, however, will be less sweeping than it appears. 

In John J. Fiero and Fiero Brothers, Inc. v. FINRA, the Second Circuit held that neither the federal securities laws nor the FINRA rules empower the regulator to bring court actions to collect disciplinary fines.  Leading to the dispute in Fiero Brothers, FINRA initiated disciplinary proceedings against Fiero Brothers, Inc., a penny-stock brokerage firm, and its owner John J. Fiero, both FINRA members, alleging that the brokerage firm engaged in manipulative and fraudulent selling practices.  As a result of the disciplinary proceedings, FINRA expelled Fiero Brothers, barred Fiero from associating with any FINRA-member firm, and imposed a $1 million fine against the firm and its principal, jointly and severally.  When Fiero Bros. and Fiero refused to pay the sanction, FINRA successfully sued to collect the unpaid fine. 

On appeal to the Second Circuit, the court ruled that FINRA lacked authority to bring lawsuits against regulated brokers and brokerage firms to collect monetary sanctions levied in enforcement actions.  The Court reasoned that while the Securities Exchange Act of 1934 and FINRA’s rules and bylaws grant the organization certain disciplinary powers over its membership – including the ability to impose sanctions – FINRA has “no authority to bring judicial actions to collect monetary sanctions.”  According to the Court, “the statutory scheme carefully particularizes an array of available remedies,” but does not include express authority “to seek judicial enforcement of the variety of sanctions [FINRA] can impose.” 

As Ms. Henriques reports, FINRA’s General Counsel, T. Grant Callery, says the organization will “continue to review the ruling and weigh our options.”  As a practical matter, two “options” emerge.  First, FINRA could seek to appeal the ruling to the Supreme Court of the United States.  This, however, is a time consuming proposition that is not guaranteed to end in a favorable decision.  A second option – and one that is eminently more likely to have the desired effect – would be for FINRA to change its rules according to the procedures set out in the Exchange Act.  In the Fiero Bros. opinion, the Second Circuit noted that “Section 19(b) of the Exchange Act establishes the mechanism by which SRO’s can change their governing rules.”  Through a rule “properly promulgated under [those] procedures,” FINRA might obtain authority to “enforce the collection of its disciplinary fines through judicial proceedings.” 

The decision has led many to believe FINRA will be powerless to effectively discipline its members, with a number of commenters concluding that the organization now has “no teeth.”  However, this conclusion is considerably overstated.  The facts presented in Fiero Bros. are strikingly narrow in the context of typical FINRA disciplinary proceedings.  FINRA does not usually impose a fine when expelling a firm or barring an individual.  In fact, the Fiero Bros. case is the only time FINRA has sought to collect a disciplinary fine through judicial proceedings.   

As a practical matter, FINRA’s regulatory powers are not substantially eroded by the Fiero Bros. ruling.  Indeed, FINRA’s General Counsel is confident that the decision will not impact the regulator’s “ability to enforce FINRA rules and securities laws, to discipline firms or protect investors.”  Even without the authority to hale a member into court, FINRA indisputably retains its two most potent regulatory powers: the authority to promulgate and enforce rules governing its members; and the power to indefinitely suspend or expel brokerage firms and bar brokers from the financial industry.  Through the threat of suspension, expulsion or debarment, FINRA will be able to continue enforcing the rules governing its members. 

We will continue to track the Fiero Bros. case, and any related action undertaken by FINRA.  Stay tuned: There may be more developments ahead.