When the US Supreme Court heard arguments in Securities and Exchange Commission v. Jarkesy last month, the justices’ questions suggested the court would likely declare the SEC’s in-house tribunal at least partially unconstitutional.
In the Jarkesy proceedings, the Fifth Circuit held that the SEC’s in-house adjudication of securities fraud claims violates the Seventh Amendment, creating further uncertainty for the Financial Industry Regulatory Authority. FINRA’s own in-house tribunal structure already faces a constitutional challenge in Alpine Securities Corp. v. FINRA.
The US Court of Appeals for the District of Columbia Circuit in July enjoined FINRA’s expedited enforcement proceeding against Alpine, the plaintiff’s securities broker, holding that Alpine was likely to succeed on the merits of its claim that FINRA, a private entity, constitutes a state actor subject to constitutional restrictions when operating in its enforcement capacity.
Alpine also argued that FINRA’s enforcement structure violates the Constitution’s Appointments Clause and the removal protections associated with the separation of powers doctrine.
Alpine has spawned additional lawsuits challenging FINRA’s constitutionality. While courts have held that FINRA writ large isn’t a government actor, Alpine and subsequent cases present an open question of law: whether FINRA operates as a state actor in the narrower context of its enforcement authority.
To answer that question, courts must examine the thorny state action doctrine, under which there are multiple tests for determining when a private actor’s conduct should be attributed to the government.
Two tests are particularly relevant to FINRA. Under the compulsion test, state action exists when the government compels a private actor to take a specific action. Under the public function test, state action exists when a private actor performs a traditional, exclusive public function.
Federal law requires FINRA to enforce the federal securities laws against its members, and a court may find this mandate renders FINRA a state actor under the compulsion test. Numerous courts have held that law enforcement is a traditional, exclusive government function. As such, a court may view FINRA’s enforcement of the federal securities laws as state action under the public function test.
Alpine and subsequent challenges to FINRA’s constitutionality follow a recent line of noteworthy cases addressing administrative power. In Lucia v. SEC, the Supreme Court held that SEC administrative law judges must be appointed in accordance with the Appointments Clause.
In Axon Enterprise v. FTC, the Supreme Court held that district courts may hear certain constitutional challenges against an agency before applicable administrative review processes are exhausted. And in Jarkesy, the court appears ready to uphold the Fifth Circuit’s ruling that the SEC’s internal adjudication of securities fraud claims violates the Seventh Amendment.
Alpine will likely be appealed to the Supreme Court. Given Jarkesy and the court’s other recent decisions, Alpine-like arguments may have a receptive audience before the current bench. The implications of the court’s eventual ruling will raise additional questions that will likely be litigated for years to come.
For instance, while Alpine argues that FINRA engages in state action even when it enforces its own rules, which have the force of law, other litigants present a more limited question—whether FINRA engages in state action when it enforces federal securities laws.
To the extent the court finds FINRA does engage in state action when it enforces federal securities laws, but not when it enforces its own rules, the impact could be relatively limited. FINRA could continue to try enforcement actions involving its rules in its in-house tribunal structure—without being subject to any constitutional restrictions.
Such a holding would require FINRA to provide constitutional protections when enforcing the federal securities laws. If the court rules that FINRA respondents are entitled to Fifth Amendment rights, FINRA presumably could accommodate assertions of those rights within its internal adjudication structure.
However, if the Jarkesy court determines that respondents are entitled to jury trials for claims arising under the federal securities laws, FINRA wouldn’t be able to bring those cases in its internal structure. Because FINRA has no private right of action under the federal securities laws, it conceivably would have to refer those cases to the SEC.
Another possible outcome in Alpine is that FINRA hearing officers will be required to be appointed by a government body under the Appointments Clause. After Lucia, the SEC stayed all of its administrative proceedings in order to rectify its Appointment Clause violations.
Nearly a year later, it lifted the stay and issued an order providing all respondents in pending proceedings an opportunity for a new hearing before an ALJ who hadn’t participated in the matter and vacating any prior opinions issued in those matters. FINRA may be required to do the same for its active proceedings involving the federal securities laws.
This outcome would be far less burdensome for FINRA. While the SEC had over 100 pending proceedings when Lucia was decided, FINRA only has 19 active proceedings. Of those, only a subset likely involve charges under the federal securities laws.
But the issue of FINRA hearing officers’ appointments may be moot based on the scope of the court’s eventual ruling in Jarkesy.
If FINRA is prohibited from bringing any enforcement actions under the federal securities laws in its in-house tribunal (because the court determines that respondents to such claims are entitled to jury trials), the only enforcement proceedings left for hearing officers to decide would involve FINRA’s internal rules. In that case, hearing officers may not have to be appointed consistent with the Appointments Clause.
A ruling that FINRA engages in state action in connection with its enforcement authority would generate challenging issues that litigants and courts will grapple with for the foreseeable future.
The cases are Alpine Securities Corp. v. FINRA, No. 23-05129, D.C. Cir.; SEC v. Jarkesy, U.S., No. 22-859, argued 11/29/23.
(Updates author bios with plaintiff’s representation in Sidney Lebental v. FINRA.)
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Rachel Mechanic and Daniel Zinman are litigation partners in Perkins Coie’s New York office. They are attorneys for the plaintiff in Sidney Lebental v. FINRA, in which the plaintiff also raises questions about FINRA’s constitutionality.
Emily Drinkwater and Benjamin Estes contributed to this article.
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