FINRA, the self-regulatory organization (SRO) responsible for overseeing broker-dealers in securities markets, now faces constitutional scrutiny about its structure, enforcement proceedings, and sanctions. In July, Judge Justin R. Walker of the U.S. Court of Appeals for the D.C. Circuit issued a concurrence that signaled genuine skepticism about FINRA’s constitutional status.

The case, Alpine Securities Corp. v. FINRA, challenges the constitutionality of the SRO and its enforcement structure.  Alpine is a repeat player in FINRA proceedings, with 45 regulatory events on its BrokerCheck record.  In the latest round, FINRA attempted to expel Alpine as a member, excluding it from the brokerage industry.  In response, Alpine opened a separate front in the dispute and filed its own suit challenging FINRA’s constitutionality.  Now, the D.C. Circuit has enjoined FINRA from expelling Alpine while it considers FINRA’s constitutional status.

The challenge arrives at a time when securities regulators have struggled before the U.S. Supreme Court. In Lucia v. SEC (2018), the SEC lost an important claim about its ability to appoint its administrative law judges without regard to the Appointments Clause of the Constitution. Just this term, in Axon Enterprise v. FTC and Cochran v. SEC (2023), the court held that statutory agency review procedures do not preclude a collateral challenge to the constitutionality of SEC enforcement proceedings.  And the court granted certiorari to hear SEC v. Jarkesy, in which the Fifth Circuit had found that the SEC’s administrative proceedings raised Seventh Amendment, non-delegation, and separation of powers concerns.

This steady drumbeat of anti-administrative state decisions opened the door for Alpine.  The Axon decision itself put fresh wind in Alpine’s sails and allowed Judge Walker to declare that Alpine’s risk of having claims resolved by an “unconstitutionally structured adjudicator” gives it the right to litigate FINRA’s constitutional status immediately.

As one of us (Edwards) has written in an article, Supreme Risk, this sort of case matters immensely because self-regulatory organizations provide both market infrastructure and oversight in a context that is in significant tension with the 18th-century constitutional framework animating decisions like Alpine. SROs play an outsized legal and economic role in capital markets and exercise enormous power delegated to them by the federal government.  As the district court noted in Alpine’s case, decades of constitutional doctrine blessed this framework.  Yet a handful of constitutional doctrines have found a receptive audience among a conservative federal judiciary in Lucia, Cochran, and other cases that challenge the existing role of SROs as private, non-governmental entities within our constitutional structure.

If Alpine wins, the broader consequences will ultimately depend on the ruling’s specifics. A broad ruling finding industry SROs incompatible with nondelegation doctrines, for instance, could render unenforceable large swaths of the stock exchange, clearing agency, and broker-dealer laws that enable American capital markets to operate. Declaring SROs unconstitutional would unravel economic power structures. In addition, a court decision declaring a keystone SRO unconstitutional could have enormous market impacts.

Consider the ramifications of a decision declaring Section 15A of the Exchange Act, which governs FINRA, an unconstitutional delegation and thus invalidating its actions.  Where does that leave the securities markets?  The law requires brokerage firms to register with a national securities association to trade securities.  Will trading continue uninterrupted if FINRA falls?  Will markets continue to act as if the FINRA rules govern, or will the resulting free-for-all be left to the SEC to manage?  Perhaps more important, what would be the systemic risks associated with concluding that such doctrines invalidate the rules of the Depository Trust Company?

A narrower ruling might leave FINRA and other SROs intact but cripple their enforcement power. Judge Walker opined in his concurrence that FINRA hearing officers appear to be “near carbon copies” of the SEC administrative law judges that were held to be subject to the Appointments Clause in Lucia. Drawing on the powers of the hearing officers – including their ability to impose sanctions – he concluded that FINRA hearing officers may well be inferior officers under Lucia, too.

In these respects, the Alpine case may yet reshape the SRO enforcement landscape.  If FINRA hearing officers are held to lack valid enforcement power, how might securities regulation fill the gap — with arbitrators, SEC administrative law judges, or perhaps even state and federal judges?  All these adjudicators sit side-by-side in securities law today.  Whether the public would be better served by having all enforcement go through public courts remains to be seen.

The problem may partly be one of error costs — how much we want to value having well-qualified and well-situated adjudicators relative to other virtues. Arbitrators, for instance, are thought to be more flexible and efficient than hearing officers. But as we write in another article, Stockbroker Secrets, under the current system of expungement proceedings, FINRA arbitrators decide whether to expunge disclosures from the public BrokerCheck complaint database. Between structural disincentives for claimants to participate in these proceedings, and the difficulty under the Federal Arbitration Act of correcting errors in these awards, FINRA could better calibrate the tradeoff between costs of error and costs of adjudicating claims by shifting these decisions from arbitration to a hearing officer program.

Alpine’s claims about accountability at FINRA look harsher in the light of the sanction it faces — expulsion from the industry.  As brokerage firms must be FINRA members to access markets, simply kicking a firm out of the club has always been FINRA’s biggest weapon.  Some have called it the industry’s “capital punishment” because expelling a firm or barring an individual ends its brokerage business. In 2017, then-Judge Brett Kavanaugh drew on the death penalty analogy in questioning whether FINRA’s expulsions of members from the industry were impermissibly punitive and beyond its power.

The debate about FINRA’s power to impose the industry “death penalty” highlights the inherent tension between industry autonomy and public interest in self-regulation.  As one of us (Tierney) has explored in a working paper, an important purpose of self-regulatory enforcement since the beginning has been to promote confidence in securities markets.  Over the years, the brokerage industry has moved from a private-club to a regulated-entity model, and in turn brokers have increasingly found that their regulators value public confidence more than reducing the severity of sanctions in response to broker complaints.

Through incapacitation and deterrence, exclusion from the industry — the punishment Alpine is objecting to here — has been thought to reduce the risk to investors of misconduct.  Yet a significant majority of these exclusions, the evidence shows, are not against those adjudicated responsible for misconduct that puts investors at risk, but rather against those who thumb their noses at FINRA’s regulatory authority.  The vast majority of the expulsions involve, for instance, allegations that the registered representative has failed to respond to FINRA’s regulatory requests.  FINRA has streamlined processes for excluding people and firms from the industry, and an example was FINRA’s expedited proceeding against Alpine for violating an earlier cease-and-desist order.  Without discounting the seriousness of allegations against Alpine, FINRA’s expulsion can’t be understood apart from Alpine’s  history with FINRA.

Challenges like Alpine and Jarkesy raise questions as to what forums securities law may be left with in situations like this: neither FINRA hearing officers nor SEC ALJs, just FINRA arbitration and Article III courts?

The goal of the FINRA backlash appears to be less about promoting public accountability and other governance virtues, and more about deterring enforcement outside Article III courts. The goal, in short, seems to be to shunt claims to a judicial forum where defense counsel believe adjudicators are more likely to be sympathetic to the industry.

This post comes to us from professors James Fallows Tierney at Chicago-Kent College of Law and Benjamin P. Edwards at the William S. Boyd School of Law at the University of Nevada, Las Vegas. They thank Professor Alex Platt for comments on this post.