WASHINGTON -- The U.S. Supreme Court closed a loophole when it ruled in Kokesh v. SEC that the Securities and Exchange Commission is limited to a five-year statute of limitations even in disgorgement orders. But FINRA, the Financial Industry Regulatory Authority, may still consider that loophole wide open – giving regulators the opportunity to route cases to FINRA that would otherwise run afoul of the five-year limit.
As an independent self-regulatory organization authorized by Congress to oversee broker-dealers, FINRA maintains its disciplinary authority stems from the contractual agreements it has with securities dealers. That understanding is cemented in at least four decisions by the SEC, which also held FINRA enforcement actions aren’t subject to the statute of limitations that applies to other securities cases.
If the SEC is right, then Kokesh doesn’t apply. But the Second Circuit Court of Appeals in New York undermined FINRA’s contract theory of enforcement in a 2011 decision, Fiero v. FINRA. In that case, the court ruled that FINRA can discipline or expel members for violations of its rules, but can’t enforce monetary fines through the courts. The Second Circuit cited the federal Securities Exchange Act, which authorizes self-regulatory organizations like FINRA (formerly the National Association of Securities Dealers) but doesn’t give them explicit access to the courts.
In Kokesh, the Supreme Court unaninously rejected the SEC’s theory that disgorgement wasn't a "penalty" under federal law and thus lay outside the statute of limitations. No court has ruled explicitly on the same question involving FINRA, But if FNRA is subject to the Exchange Act, as the Second Circuit ruled, and disgorgement is a monetary penalty with a five-year statute of limitations, as the Supreme Court ruled in Kokesh, then it would face the same time limits as the SEC.
FINRA declined comment on this seeming conflict between Kokesh and Fiero on one side and the SEC rulings on the other. But John Fahy, a former SEC enforcement attorney who practices with Whitaker Chalk Swindle & Schwartz in Fort Worth, said regulators may use differing understandings of enforcement authority to game the system. The controlling law governing FINRA – established through SEC administrative rulings – says it can pursue brokers for disgorgement and penalties outside the five-year statute of limitations while the SEC can’t..
“This can create the risk of regulator-shopping in certain matters,” Fahy said “Simply put, due to the SEC opinions on FINRA’s statute of limitations, FINRA is now in a more advantageous position in pursuing old cases than the SEC is.”
While FINRA’s authority is limited to broker-dealers and “affiliated persons,” that includes firms employing more than 630,000 securities brokers. And unlimited disgorgement can be a powerful tool, allowing regulators to claw back years of commissions and ill-gotten gains. The SEC rulings declaring FINRA to be exempt from the statute of limitations include In the Matter of William D. Hirsh and In the Matter of Stephen J. Gluckman.
A broker-dealer who wanted to challenge a FINRA order extending past five years would face an expensive, uphill battle, Fahy said. The first step would be going before a three-member FINRA panel chaired by a FINRA employee. Since FINRA considers SEC rulings to be controlling law, it's unlikely the panel would rule in the challenger’s favor. After the hearing a respondent can appeal to FINRA’s National Adjudicatory Council, or the NAC. Once again, the SEC opinions will be controlling law at the NAC.
After that, the challenger can appeal to the SEC. The agency can discard its earlier opinions, but that’s not likely to happen. Finally, the respondent can appeal the SEC’s opinion and order to the D.C. Circuit Court of Appeals or the federal appeals court in its region. By then the challenger will have spent several years and hundreds of thousands, if not millions, of dollars in legal fees while operating under the cloud of FINRA sanctions.
The stakes make it unlikely anyone will seriously test this seeming loophole in the law. Kokesh, by itself, may not prevent FINRA from going after assets its targets accumulated years before the five-year statute of limitations began running.