DC Circuit Sustains FINRA Rule 2030 Against GOP Challenge

June 19, 2019

The United States District Court for the District of Columbia waded into the debate about whether the SEC may regulate political donations by investment advisers and placement agents through rules promulgated by the self-regulatory-organization FINRA. All of which falls under the financial reform rubric of Pay-to-Play. For those of us fed up with rampant political corruption, such rules and attendant enforcement are welcome relief. For those who see this as a nation of laws, such well-intentioned regulation and enforcement may be viewed as wrongly trampling on the Constitution. Indeed, the road to Hell is paved with good intentions -- as is the road to the courthouse.

Pay-To-Play Rules

As set forth in part in the "Executive Summary" to Financial Industry Regulatory Authority ("FINRA") "Political Contributions / SEC Approves FINRA "Pay-To-Play" and Related Rules / Effective Date: August 20, 2017" (FINRA Regulatory Notice 16-40 / October 2016) https://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-16-40.pdf [Ed: Footnotes omitted]:

The Securities and Exchange Commission (SEC) approved FINRA Rules 2030 (Engaging in Distribution and Solicitation Activities with Government Entities) and 4580 (Books and Records Requirements for Government Distribution and Solicitation Activities) to establish "pay-to-play" and related rules regulating the activities of member firms that engage in distribution or solicitation activities for compensation with government entities on behalf of investment advisers.

As more fully explained under the FINRA Regulatory Notice section "Background & Discussion" [Ed: Footnotes omitted]:

In July 2010, the SEC adopted Rule 206(4)-5 under the Investment Advisers Act of 1940 (Advisers Act) addressing pay-to-play practices by investment advisers (the SEC Pay-to-Play Rule). The SEC Pay-to-Play Rule prohibits, in part, an investment adviser and its covered associates from providing or agreeing to provide, directly or indirectly, payment to any person to solicit a government entity for investment advisory services on behalf of the investment adviser unless the person is a "regulated person." The SEC Pay-to-Play Rule defines a "regulated person" to include a member firm, provided that: (a) FINRA rules prohibit member firms from engaging in distribution or solicitation activities if certain political contributions have been made; and (b) the SEC, by order, finds that such rules impose substantially equivalent or more stringent restrictions on member firms than the SEC Pay-to-Play Rule imposes on investment advisers and that such rules are consistent with the objectives of the SEC Pay-to-Play Rule.

Based on this regulatory framework, FINRA Rule 2030 is modeled after the SEC Pay-to-Play Rule, and imposes restrictions on member firms engaging in distribution or solicitation activities that are substantially equivalent to those imposed on investment advisers by the SEC Pay-to-Play Rule. On September 20, 2016, the SEC, by order, found that FINRA Rule 2030 imposes substantially equivalent or more stringent restrictions on members firms than the SEC Pay-to-Play Rule imposes on investment advisers and is consistent with the objectives of the SEC Pay-to-Play Rule. Furthermore, FINRA Rule 4580 imposes recordkeeping requirements on member firms in connection with political contributions. . . .

SIDE BARREAD the full-text of FINRA Rule 2030 

The GOP Gulps

Petitioners the New York Republican State Committee ("NYGOP") and the Tennessee Republican Party petitioned United States Court of Appeals for the District of Columbia Circuit ("DCCir")  for review of the SEC's Order approving FINRA Rule 2030. Petitioners argued that the:
  1. SEC did not have authority to enact the Rule; 
  2. SEC Order adopting the FINRA Rule is arbitrary and capricious because there was insufficient evidence it was needed; and 
  3. FINRA Rule violates the First Amendment to the Constitution of the United States. 
In a Majority Opinion by Ginsburg, J. and Pillar, J. with Sentelle, J. dissenting, the DCCir held that the SEC had acted within its authority in adopting FINRA Rule 2030. New York Republican State Committee and Tennessee Republican Party, Petitioners, v. Securities and Exchange Commission, Respondent (Opinion, United States Court of Appeals for the District of Columbia Circuit, 18-1111 / June 18, 2019) 

Investment Adviser Payola

In explaining the genesis for FINRA Rule 2030, the DCCir Opinion asserts that:

[B]y 2010 an increasing number of enforcement actions had revealed that some of these elected officials chose investment advisers based upon whether the would-be adviser had given them money or donated to their campaign. 75 Fed. Reg. at 41019/3-20/3; id. at 41039 n.290. For example, the SEC brought cases against the former Treasurer of the State of Connecticut and other defendants, alleging the Treasurer had allocated pension fund investments to fund managers in exchange for political contributions and other payments made through the Treasurer's "friends and political associates." . . .

Pages 3 - 4 of DCCir Opinion

DCCir explained that the SEC adopted a rule in 2010 (modeled on the Municipal Securities Rulemaking Board ("MSRB") Rule G-37) regulating the political contributions of firms and individuals registered under the Investment Advisers Act of 1940. 

Closing a Loophole

Notwithstanding its adopted Rule 206(4), the SEC purportedly harbored concerns that advisers would attempt to circumvent the prohibitions through the use of placement agents as an "indirect" conduit for funds from the advisers to government officials capable of awarding investment contracts. In recognition of that potential loophole, the SEC allowed an adviser to use a placement agent, provided same was a FINRA member firm -- which prompted the drafting and subsequent SEC-approval of FINRA Rule 2030. In meshing the SEC and FINRA pay-to-play rules together, the DCCir found in part that:

In other words, if a placement agent makes a contribution to a government official who can influence a government entity's choice of an investment adviser, see Rule 2030(g)(8) (defining "official"), then the placement agent must wait two years before he or his firm can accept payment for soliciting that government entity on behalf of a client. The "two-year time-out" is intended to serve as a "cooling-off period during which the effects of a political contribution on the selection process can be expected to dissipate."  . . . 

Page 6 of DCCir Opinion

A Matter of Standing

In addressing Petitioners' standing to sue, the DCCir noted the "constitutional minimum" standard was for those parties to demonstrate:

 (1) they have suffered an injury-in-fact, (2) caused by the challenged conduct; and (3) a favorable decision is likely to redress that injury. . . .

The DCCir noted its skepticism in finding standing where no Petitioner is regulated by the challenged rule, as was the case here. Notwithstanding, the Court found that NYGOP would be harmed if contributors ceased giving funding, and, accordingly, that circumstance would constitute a "concrete and particularized injury for purposes of Article III standing." Similarly, the Court found that NYGOP met its burden of proof as to the substantial risk it was exposed to by the FINRA Rule

A Matter of Authority

Having deemed Petitioner NYGOP as having standing to challenge FINRA Rule 2030 as "an ultra vires regulation of campaign finance," DCCir then considers whether the SEC had authority to approve the self-regulatory-organization's rule. In part, the DCCir Opinion explains that [Ed: Footnotes omitted]:

[R]egulating pay-to-play practices in the municipal bond market is within the authority of the SEC to reduce distortion in financial markets: 

"Pay to play" practices raise artificial barriers to competition for those firms that either cannot afford or decide not to make political contributions. Moreover, if "pay to play" is the determining factor in the selection of an underwriting syndicate, an official may not necessarily hire the most qualified underwriter for the issue.... "Pay to play" practices undermine [just and equitable] principles [of trade] since underwriters working on a particular issuance may be assigned similar roles, and take on equivalent risks, but be given different allocations of bonds to sell - resulting in differing profits - based on their political contributions or contacts

The Majority similarly rebuffs Petitioners' argument that Congress could not have intended to delegate to a mere agency a decision of the magnitude inherent in FINRA Rule 2030 -- which was manifested by the SEC's role in approving the self-regulatory-organization's rule. Pointedly, Petitioners assert that Rule 2030 interferes with Congressional prerogatives as set forth, for example, in the Federal Election Campaign Act of 1971 ("FECA"). The DCCir views this argument through the prism of "coexistence" between FECA and the Securities and Exchange Act of 1934 -- which prompts the Court to ask whether the former take precedence over the latter or do the two merely overlap. The DCCir opts to exercise its right to ascertain congressional intention and concludes that FECA was not intended to repeal the Exchange Act's Pay-to-Play rulemaking authority.

First Amendment

Finally, the DCCir Opinion rejects Petitioners' argument that FINRA Rule 2030 violates the First Amendment. Essentially, the Court found that Rule 2030 was "closely drawn" in order to further a "sufficiently important" governmental interest -- which sets the groundwork for the application of a standard of review that is below "strict scrutiny." Further, the DCCir notes that MSRB Rule G-37 (which is the blueprint for FINRA Rule 2030) was found by the Supreme Court to be in furtherance of a legitimate and compelling government interest. 

The Dissent: Dismiss Rather Than Deny

In his Dissent, Judge Sentelle states that he would dismiss the Petition for want of jurisdiction rather than deny, as the Majority did. In essence, the Dissent would not have even considered the substantive issues on appeal because the Petitioners would not have been deemed eligible to present them to the Court. Unlike the Majority, Judge Sentelle found the Petitioners' lacked standing and characterized his colleagues' finding as basically endorsing speculation about the decisions of independent actors not before the court. Such judicial rumination is viewed by Sentelle as little more than a theory of speculative future injury that is not impending -- moreover, he admonishes that:

even if petitioners have established that they suffer injury-in-fact, they have not established that the injury-in-fact is caused by the act of respondent. Both this court and the Supreme Court have held that when the establishment of injury depends on the volitional act of a third party, the claimant has not established standing as against the respondent. 

Pages 11 - 12 of the DCCir Opinion

Bill Singer's Comment

I am torn by the DCCir Opinion because I believe that it furthers a legitimate and compelling interest to remove the taint of corruption from the process of hiring financial advisers for state and local governments. Also, I believe that the DCCir largely, essentially, basically got the Pay-to-Play issue correct --- but, I'm uneasy about the Court's lack of analysis about FINRA's role within the present Wall Street regulatory scheme. As with many things in life and law, it's may be the right result achieved via the wrong route. Close your eyes? Hold your nose?

The DCCir did not undertake enough analysis about FINRA's unique role as a non-governmental actor within the regulatory scheme. Similarly, I don't think that Petitioners made enough of an argument about how the SEC itself is "indirectly" acting through a non-governmental regulator when it comes to promulgating Pay-to-Play rules. Reduced to its essence, the SEC approved a rule by a self-regulatory-organization that prohibits FINRA member firms from engaging in distribution or solicitation activities if certain political contributions have been made. Ultimately, NYGOP is the recipient of such contributions, which means that FINRA is interfering with a political party's ability to raise funds. As a lawyer cognizant of due process and First Amendment rights, I'm not at ease with the DCCir's rationale. 

How is it fair for FINRA to promulgate rules that negatively impact NYGOP? NYGOP is not a FINRA member firm. NYGOP has no vote whatsoever over any rule proposal or elective office at FINRA. NYGOP is fully disenfranchised at FINRA. Speaking of those disenfranchised at FINRA, let's not forget to include public investors, associated persons, and other non-member-firm constituencies. 

If and when this appeal makes its way to the Supreme Court, it may prompt a long-overdue assessment of the constitutionally of continuing to allow the SEC to indirectly engage in rulemaking and enforcement through a non-governmental FINRA. One has to wonder why the SEC was impotent when it came to promulgating its own rules to prohibit what FINRA Rule 2030 covers. That lack of authority suggests the need to bolster the SEC's power but not to permit that same federal regulator to "job out" its regulatory work to an independent contractor.

As a founder and leader of the FINRA Dissident/Reform Movement, I welcome  judicial scrutiny of FINRA, and hope that it will ring the death knell of the now-outdated 1930's Wall Street self regulation. In 2019, we need to replace the "self-regulatory-organization" with a more expansive and inclusive "private-sector-regulator," which would offer representative seats on a Board to public investors, associated persons, issuers, state regulators, broker-dealers, investment advisers, and other financial services providers.