FINRA Wins Scottsdale Capital Advisors Motion to Dismiss

May 9, 2016

This is an update of "Scottsdale Sues FINRA In Edgy Effort To Halt Disciplinary Case" ( Blog, March 28, 2016)

Wall Street is regulated by the federal Securities and Exchange Commission ("SEC"), by state securities divisions, and by the self-regulatory organization ("SRO") the Financial Industry Regulatory Authority ("FINRA"). On top of that regulatory regime, we should also add the Federal Bureau of Investigation, the Department of Justice, the United States Attorneys, the states's Attorneys General, and, in some cases, local county or district attorneys. For such a prodigious tower of oversight, it's puzzling how poorly it all works -- or fails to. Feuding regulators battle over turf and precious media exposure instead of walking the beat. Competing regulators inefficiently pursue similar investigations seeking the same documents resulting in redundant charges. Adding insult to injury, public investors and industry participants frequently complain about being sent from an examiner to a supervisor to an office to a division to a department to an agency -- all of which culminates with no one able to solve a problem or willing to take responsibility. The process is endless, 
suffocating, and impotent.

For much of my three-plus decades on Wall Street, I have waged an often lonely but persistent battle in favor of regulatory reform. Pointedly, I have long advocated the end of SROs and a modernization of the tired policies and practices in place at the SEC. See, for example: End The Politics Of Wall Street Regulation: Decentralize FINRA And The SEC ( BlogNovember 16, 2011). A recent case filed against FINRA in federal court raises many issues about the state of Wall Street regulation and underscores the need to bring about overdue reform.

Case In Point

On March 22, 2016, a FINRA member firm; one of the firm's founders and Director; and three registered representatives filed a Complaint against FINRA in the United States District Court for the District of Maryland ("DMD") seeking injunctive and declaratory relief. Scottsdale Capital Advisors Corporation, John J. Hurry, Timothy B. DiBlasi, and Darrell Michael Cruz, Plaintiffs, v. Financial Industry Regulatory Authority, Inc., Defendant (Complaint, 16-CV-00860, March 22, 2016). Plaintiff Scottsdale Capital Advisors Corporation ("SCA") is a broker-dealer and registered investment advisor; Plaintiff Hurry is a founder and Director of SCA; Plaintiff DiBlasi is SCA's Chief Compliance Officer; and Plaintiff Cruz was formerly SCA's President.  The Complaint seeks

A. An order and judgment preliminarily and permanently enjoining FINRA from continuing disciplinary proceeding against Plaintiffs (FINRA Case No. 2014041724601).

B. An order and judgment declaring that FINRA lacks statutory authority under the Exchange Act to bring disciplinary proceedings against member firms or their associated persons premised upon alleged violations of the Securities Act. 

 Page 19 of the Complaint

READ the FINRA v. Scottsdale et al Disciplinary Complaint

FINRA Disciplinary Proceeding

As more fully explained in the "Background" section of the Complaint, at the core of this dispute is an ongoing FINRA disciplinary proceeding:

26. Since SCA's formation in 2001, the firm has become a market leader in microcap securities trading.

27. In 2013, Mr. Hurry organized Cayman Securities Clearing and Trading SEZC Ltd. ("CSCT") in the Special Economic Zone of the Cayman Islands to serve as an offshore broker for foreign clients. CSCT became a customer of SCA and, through its account there, deposited and liquidated penny stocks on behalf of CSCT's own customers.

28. On May 15, 2015, FINRA commenced a disciplinary proceeding against Plaintiffs. In brief, FINRA's complaint alleges that (i) certain transactions that CSCT routed through SCA on behalf of specified CSCT customers violated Section 5 of the Securities Act and (ii) Plaintiffs' supervisory processes and procedures were not reasonably designed to detect and prevent violations of Section 5. As a result of these purported Section 5 violations, the Complaint charges Plaintiffs with violating FINRA Rule 2010, which requires members to "observe high standards of commercial honor and just and equitable principles of trade."

29. In its complaint, FINRA requests that the Hearing Officer order one or more of the sanctions listed in FINRA Rule 8310. Rule 8310(a) authorizes FINRA to impose a variety of penalties on its members, including censure, fines, suspension of FINRA membership or registration, expulsion from FINRA, cancellation or revocation of FINRA membership, suspension from or bars on association with FINRA members, entry of temporary or permanent cease-and-desist orders, and "any other fitting sanction." FINRA R. 8310(a).

30. On December 11, 2015, Plaintiffs moved for summary disposition before the FINRA Hearing Officer assigned to their disciplinary proceeding. Plaintiffs' submission rested principally on the jurisdictional argument advanced in this Complaint.

31. On February 26, 2016, the Hearing Officer, a FINRA-employed attorney, denied Plaintiffs' motion, holding, in effect, that FINRA can use its general ethical rule to enforce any of the federal securities laws, notwithstanding the contrary text in FINRA's enabling legislation.

Pages 10 - 11 of the Complaint

Exhaustion of Administrative Remedies

The Exhaustion of Administrative Remedies Doctrine ("Exhaustion Doctrine") is cited as keeping the machinery of regulation well-oiled. At its core, the Exhaustion Doctrine prevents a party from seeking the intervention of the courts into a given regulator's disciplinary process until such time as all the prerequisite administrative remedies have been exhausted. Advocates of the Exhaustion Doctrine argue that it supports the integrity of the regulatory process by avoiding the delays and bad-faith that arise when defendants/respondents prematurely run to a courthouse in lieu of exhausting the statutorily proscribed scheme of hearings and appeals. Cynics see the Exhaustion Doctrine as a way for the courts to cut down on their caseload by not getting involved in an agency's or organization's administrative procedures until there is some "final" decision. Historically, courts are loathe to interrupt the regulatory administrative process on a "piecemeal " basis and have opined that it is best to ensure that appeals arrive at the courts's doorsteps in a relatively ripe condition with a full record.  Similarly, courts generally defer to the purported expertise of regulators when it comes to interpreting and applying the applicable regulatory rules and regulation. 

Short Circuiting the Pathway

In light of the above Exhaustion Doctrine, the Scottsdale Complaint is an edgy undertaking because Plaintiffs are trying to avoid exhausting their administrative remedies via a route that entails a FINRA Office of Hearing Officers hearing and then an appeal to a FINRA National Adjudicatory Council hearing and then an appeal to the SEC and, then, and only then, an appeal to the federal courts. In Plaintiffs' federal lawsuit against FINRA, they are attempting to short-circuit that administrative-remedies pathway and bring their grievances against the SRO to a United States District Court. In justifying an exception to the Exhaustion Doctrine, Plaintiffs argue, in part, that:

[F]INRA's in-house disciplinary action against them exceeds FINRA's statutory authority under the Exchange Act, rendering the entire proceeding ultra vires. Although Plaintiffs ultimately may obtain federal appellate review of this claim after several administrative appeals this belated judicial intervention will not be meaningful, as submission to an unlawful proceeding constitutes the very harm that Plaintiffs seek to avoid.

Pages 5 - 6 of the Complaint

As set forth in the "Introduction" section of the Complaint:

1. Plaintiffs bring this action for injunctive and declaratory relief to prevent FINRA from further proceeding against them with a disciplinary action premised on claims that exceed the organization's expressly limited authority under the Securities Exchange Act of 1934 (the "Exchange Act").

2. FINRA is a registered securities association and self-regulatory organization that operates as a private regulatory body for broker-dealers. As a practical matter, any broker-dealer that desires to conduct business in the United States is required to register with FINRA.

3. Plaintiffs are a FINRA-registered broker-dealer (Scottsdale Capital Advisors Corporation ("SCA")), its founder (Mr. Hurry), and two of its officers (Mr. DiBlasi and Mr. Cruz). FINRA has initiated a disciplinary proceeding against Plaintiffs (FINRA Case No. 2014041724601), raising allegations premised on supposed violations of Section 5 of the Securities Act of 1933 (the "Securities Act"), which generally prohibits the public distribution of unregistered securities absent an applicable exemption. The Section 5 allegations are the predicate for charged violations of FINRA Rule 2010, which states that "[a] member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade." FINRA R. 2010.

4. FINRA's disciplinary authority is derived from, and governed by, Sections 15A and 19 of the Exchange Act. Together, these provisions empower the organization to discipline its members for violations of "this chapter," "the rules and regulations thereunder," and FINRA's own rules. Because the Exchange Act occupies a different chapter in the United States Code from the Securities Act, the plain and unambiguous text of FINRA's enabling legislation forecloses disciplinary actions premised upon alleged violations of the Securities Act or federal securities laws other than the Exchange Act.

5. Before seeking relief from this Court, Plaintiffs raised this jurisdictional argument to the FINRA Hearing Officer assigned to their disciplinary proceeding. On February 26, 2016, the Hearing Officer, an attorney employed by FINRA, rejected Plaintiffs' argument and adopted FINRA's view that the organization can confer upon itself jurisdiction to enforce any law it chooses, despite the explicit textual limitations in the Exchange Act, as long as the conduct it aims to regulate relates to trade. This disregard of the statutory limits on FINRA's jurisdiction renders the disciplinary proceeding ultra vires and necessitates this Court's intervention.

6. The FINRA disciplinary proceeding is scheduled for a two-week hearing commencing June 13, 2016, in Los Angeles, California. Preparation for the hearing, including the completion of witness and exhibit lists and the submission of pre-hearing briefing, will begin imminently, with deadlines approaching in mid-April.

7. Declaratory and injunctive relief is necessary to prevent Plaintiffs from being compelled to submit to an ultra vires administrative proceeding and from suffering irreparable reputational and financial harm-all without meaningful judicial review.

Pages 3 -4 of the Complaint

In amplifying their positions, Plaintiffs explain that:

18. Plaintiffs' claims are not within the particular expertise of FINRA or the SEC. FINRA's expertise concerns the liability provisions of the Exchange Act and related issues affecting broker-dealers. The SEC's expertise concerns the substantive portions of the federal securities laws. Plaintiffs here assert claims regarding the proper interpretation of the scope of FINRA's enabling legislation, a subject implicating general principles of statutory interpretation and ascertainment of congressional intent. These principles bear no relation to the substantive expertise of FINRA or the SEC; to the contrary, they are within the core competence of the federal judiciary.]

Page 6 of the Complaint

Exceptions to the Exhaustion Doctrine

In seeking to detour around the Exhaustion Doctrine, Plaintiffs pointedly cite to five examples of exceptions that support their approach. First, Plaintiffs argue that FINRA's disciplinary proceeding exceeds the SRO's authority under the Exchange Act. Second, that Plaintiffs are not seeking to embroil DMD in the substantive regulatory charges inherent in FINRA's pending disciplinary action but, to the contrary, are seeking injunctions and declaratory judgments that are properly within the court's authority. Further, Plaintiffs assert that they will suffer "irreparable harm" if forced to exhaust their administrative remedies by participating in FINRA hearings and appeals and, thereafter, an appeal to the SEC and, thereafter, and only thereafter, filing an appeal to a federal court. Additionally, Plaintiff's cite to an established exception to the Exhaustion Doctrine that arises when it would be "futile" to pursue the Exhaustion Doctrine. Finally, Plaintiffs assert that FINRA lacks the institutional capacity "to neutrally assess the limits of its own statutory jurisdiction."

FINRA v. Scottsdale et al (Complaint, 2014041724601, May 5, 2015)

Scottsdale Capital Advisors Corporation, John J. Hurry, Timothy B. DiBlasi, and Darrell Michael Cruz, Plaintiffs, v. Financial Industry Regulatory Authority, Inc., Defendant (Complaint, 16-CV-00860, March 22, 2016)

For more details on the background to the disputes between FINRA and SCA, READ:
UPDATE May 9, 2016

On April 26, 2016, DMD ordered that Defendant FINRA's Motion to Dismiss be granted and that Plaintiffs' Complaint be dismissed for lack of subject matter jurisdiction. Scottsdale Capital Advisors Corporation, John J. Hurry, Timothy B. DiBlasi, and Darrell Michael Cruz, Plaintiffs, v. Financial Industry Regulatory Authority, Inc., Defendant (Order, DMD, 16-CV-00860, April 26, 2016)

Have we heard the end of this dispute?  Hardly. On April 27, 2016, Plaintiffs filed a Notice of Appeal with the the United States Court of Appeals for the Fourth Circuit. See, 4Cir Notice of Appeal.