FINRA Schrodinger Cat Is Dead, Alive, and a Zombie

In quantum physics, the famous Schrodinger's Cat experiment illustrates the difficulty of knowing when the so-called "quantum superposition" ends. In simpler terms, physicists had unintentionally adopted conflicting positions that amounted to proof that at any given time you could have one thing in two states -- sort of like a cat in a box that was dead or alive. Of course, the laws of physics tend to require an either/or choice, so the only way to know whether the proverbial cat was dead or alive was to look inside the box. Which may explain why so many of us failed High School math and science. On Wall Street, we have added a third possibility to the cat's life or death; namely, that the cat may also be a zombie and, therefore, one of the living dead.

IRS Says FINRA Cat is Governmental Actor

In "IRS Says FINRA Schrodinger Cat Has Three Lives" (BrokeAndBroker.com Blog, June 16, 2016), we considered an Internal Revenue Service ("IRS") finding that the Financial Industry Regulatory Authority is a governmental actor and, accordingly, the self-regulatory organization's fines are not tax deductible. In Internal Revenue Service Memorandum (Office of Chief Counsel, No. 201623006 /  June 3, 2016):

ISSUE

Whether the Financial Industry Regulatory Authority (FINRA) is a "corporation or other entity serving as an agency or instrumentality" of the government of the United States for purposes of section 1.162-21(a)(3) of the Income Tax Regulations.

CONCLUSION

FINRA is a corporation serving as an agency or instrumentality of the government of the United States for purposes of section 1.162-21(a)(3) when it is performing its federally mandated duties under the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq., of conducting enforcement and disciplinary proceedings relating to compliance with federal securities laws, regulations, and FINRA rules promulgated pursuant to that statutory and regulatory authority.

LAW AND ANALYSIS

Section 162(f)

Section 162(f) of the Code provides that no deduction shall be allowed under section 162(a) for any fine or similar penalty paid to a government for the violation of any law. Section 1.162-21(a) of the Income Tax Regulations provides that no deduction shall be allowed under section 162(a) for any fine or similar penalty paid to:

(1) The government of the United States, a State, a territory or possession of the United States, the District of Columbia, or the Commonwealth of Puerto Rico;

(2) The government of a foreign country; or

(3) A political subdivision of, or corporation or other entity serving as an agency or instrumentality of, any of the above.

FINRA is an Agency or Instrumentality Under the Guardian Industries Test

FINRA's restated certificate of incorporation, the delegation to FINRA Regulation, Inc., and the applicable federal securities laws and regulations all clearly show FINRA's role as an SRO conducting federally-mandated enforcement and disciplinary proceedings relating to the federal securities laws and regulations. FINRA enforces compliance with the Securities Exchange Act, SEC regulations, and FINRA's own rules. FINRA does so by bringing disciplinary proceedings to adjudicate violations, which are subject to review by the SEC. Saad v. SEC, 718 F.3d 904, 907 (D.C. Cir. 2013). "[W]here FINRA enforces statutory or administrative rules, or enforces its own rules promulgated pursuant to statutory or administrative authority, it is exercising the powers granted to it under the Exchange Act. Indeed, FINRA's powers in that regard are subject to divestment by the SEC under Section 19(g)(2) of that Act." Fiero, 660 F.3d at 575-576. The court in Fiero held that Congress did not empower FINRA to bring judicial actions to enforce its own fines; however, as the court noted, the SEC asserts the authority to issue an order affirming sanctions, including fines, imposed by FINRA, and to bring an action in a federal district court to enforce that order. See id. at 575 n.7.

The SEC reviews sanctions imposed by FINRA to determine whether they impose any burden on competition not necessary or appropriate, or are excessive or oppressive. Saad, 718 F.3d at 910. The court reviews the SEC's conclusions regarding sanctions to determine whether those conclusions are arbitrary, capricious, or an abuse of discretion. Id.; Siegel v. SEC, 592 F.3d 147,155 (D.C. Cir. 2010), cert. denied, 560 U.S. 926 (2010). Although the SEC has express statutory authority to seek judicial enforcement of penalties and to seek monetary penalties for violations of the federal securities laws, the SEC is prohibited from bringing an action against any person for violation of, or to command compliance with, the rules of a SRO unless it appears that (1) such SRO is unable or unwilling to take appropriate action against such person in the public interest and for the protection of investors, or (2) such action is otherwise necessary or appropriate in the public interest or for the protection of investors. Fiero, 660 F.3d at 574-575.

If a fine is imposed on a taxpayer for violation of the securities laws and regulations, the deductibility of the fine should not depend on whether the same type of bad conduct is being punished by the SRO or directly by the SEC. Otherwise, there would be inconsistent treatment of similarly situated taxpayers. Furthermore, deductibility of the fine should not depend on whether the taxpayer pays a fine to the SRO without contesting it or whether the taxpayer eventually pays the fine after exhausting all levels of review.

FINRA has been delegated the right to exercise part of the sovereign power of a government, it performs an important governmental function, and it has the authority to act with the sanction of government behind it. Moreover, FINRA has absolute immunity with respect to actions taken in furtherance of its regulatory duties. Lobaito v. Fin. Indus. Regulatory Auth., Inc., 599 Fed. Appx. 400 (2d Cir. 2015), cert. denied, 193 L. Ed. 2d 445 (2015); Santos-Buch v. Fin. Indus. Regulatory Auth., Inc., 591 Fed. Appx. 32 (2d Cir. 2015), cert. denied, 136 S. Ct. 43 (2015). Therefore, under the Guardian Industries test, FINRA is a corporation serving as an agency or instrumentality of the government of the United States for purposes of section 1.162-21(a)(3) when it is performing its federally-mandated duties under the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq., of conducting enforcement and disciplinary proceedings relating to compliance with federal securities laws, regulations, and FINRA rules promulgated pursuant to that statutory and regulatory authority. We note that section 162(f) would not apply to a fine paid to FINRA solely for a violation of a "house-keeping" rule that is a matter of private contract between FINRA in its capacity as a professional association and its members.

When exercising these functions, SROs act under color of federal law as deputies of the federal government. 

. . .

In fact, the internal appeals and administrative-review processes created by the Exchange Act confirm that no private right exists. Those avenues of relief satisfy the Exchange Act's requirement that SROs "provide a fair procedure for the disciplining of members and persons associated with members," and that they "adopt rules establishing an administrative process for disputing the accuracy of information provided in response to inquiries" about affiliated persons. See 15 U.S.C. § 78o-3(b)(8), (i)(3).

. . .

If actions like Turbeville's are permitted, fifty state courts would be authorized to supervise FINRA's regulatory conduct and its application of its internal, SEC-approved rules through the vehicle of state tort law. And given SROs' front-line role in enforcing federal securities laws, such review would in turn lead to state-court supervision of the Exchange Act's securities-regulation regime writ large.

That these remedies leave something to be desired does not change the analysis. The Supreme Court long ago observed, "[T]he fact that a federal statute has been violated and some person harmed does not automatically give rise to a private cause of action in favor of that person." Touche Ross, 442 U.S. at 568, 99 S. Ct. at 2485 (internal quotation marks omitted) (quoting Cannon v. Univ. of Chi., 441 U.S. 677, 688, 99 S. Ct. 1946, 1953 (1979)). Although a person regulated by an SRO might find the prescribed remedies incapable of fully assuaging the reputational harm he suffered as a result of the SRO's regulatory and disciplinary conduct, he chose to accept those limitations on recovery by affiliating himself with an SRO-governed firm.

No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a Grand Jury, except in cases arising in the land or naval forces, or in the Militia, when in actual service in time of War or public danger; nor shall any person be subject for the same offense to be twice put in jeopardy of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

Most of the provisions of the Fifth Amendment, in which the self-incrimination clause is embedded, are incapable of violation by anyone except government in the narrowest sense. No private body, however close its affiliations with the government, can hold a person 'to answer for a capital or otherwise infamous crime' without an indictment . . .

(1) he was "obligated, under FINRA rules, to answer all questions asked by FINRA staff;" (2) FINRA "is not a governmental agency, and thus, does not recognize the Fifth Amendment privilege against self-incrimination in any of its proceedings, including an OTR;" (3) should he "refuse to answer any questions based on an assertion of the privilege, [he] may be subject to a FINRA disciplinary action and the imposition of sanctions, including a bar from the securities industry, suspension, censure, and/or fine;" and (4) "FINRA is subject to oversight by the SEC and routinely provides the SEC with access to its files."

B. Testimony

If your testimony is taken, you should be aware of the following:

1. Record. Your testimony will be transcribed by a reporter. If you desire to go off the record, please indicate this to the Commission employee taking your testimony, who will determine whether to grant your request. The reporter will not go off the record at your, or your counsel's, direction.

2. Counsel. You have the right to be accompanied, represented and advised by counsel of your choice. Your counsel may advise you before, during and after your testimony; question you briefly at the conclusion of your testimony to clarify any of the answers you give during testimony; and make summary notes during your testimony solely for your use.

If you are accompanied by counsel, you may consult privately. If you are not accompanied by counsel, please advise the Commission employee taking your testimony if, during the testimony, you desire to be accompanied, represented and advised by counsel. Your testimony will be adjourned once to afford you the opportunity to arrange to be so accompanied, represented or advised. You may be represented by counsel who also represents other persons involved in the Commission's investigation. This multiple representation, however, presents a potential conflict of interest if one client's interests are or may be adverse to another's.

If you are represented by counsel who also represents other persons involved in the investigation, the Commission will assume that you and counsel have discussed and resolved all issues concerning possible conflicts of interest. The choice of counsel, and the responsibility for that choice, is yours.

. . .

5. Fifth Amendment and Voluntary Testimony. Information you give may be used against you in any federal, state, local or foreign administrative, civil or criminal proceeding brought by the Commission or any other agency. You may refuse, in accordance with the rights guaranteed to you by the Fifth Amendment to the Constitution of the United States, to give any information that may tend to incriminate you. If your testimony is not pursuant to subpoena, your appearance to testify is voluntary, you need not answer any question, and you may leave whenever you wish. Your cooperation is, however, appreciated.

Financial Industry Regulatory Authority, Inc. ("FINRA") is a private not-for-profit corporation and a self-regulatory organization that is registered with the Securities and Exchange Commission ("SEC") as a national securities association pursuant to § 15A of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78o-3. Nat'l Ass'n of Sec. Dealers, Inc. v. SEC, 431 F.3d 803, 804 (D.C.Cir.2005).[2] "By virtue of its statutory authority, [FINRA] wears two institutional hats: it serves as a professional association, promoting the interests of its members, and it serves as a quasi-governmental agency, with express statutory authority to adjudicate actions against members who are accused of illegal securities practices and to sanction members found to have violated the Exchange Act or . . . [SEC] regulations issued pursuant thereto." Id. (internal citations omitted); 15 U.S.C. § 78o-3(b)(7). Disciplinary actions brought by FINRA's Department of Enforcement may be adjudicated before a FINRA Hearing Panel and appealed to the FINRA National Adjudicatory Council. 431 F.3d at 804. FINRA must notify the SEC of any final disciplinary action taken against a member. 15 U.S.C. § 78s(d)(1). The SEC may review FINRA's decision de novo pursuant to a petition from the aggrieved member; the SEC may also review the action sua sponte. Id. § 78s(d)-(e); 431 F.3d at 804. A person aggrieved by a final order of the SEC may obtain judicial review by filing a petition with the United States Court of Appeals for the District of Columbia Circuit or for the circuit in which he resides or has his principal place of business. 15 U.S.C. § 78y(a)(1). This statutory system authorizing self-regulatory organizations to act as quasi-governmental agencies in disciplining members for federal securities law violations has existed for over 70 years. See Nat'l Ass'n of Sec. Dealers v. SEC, 431 F.3d at 804.

As held in Solomon, SROs have historically been viewed as private, non-governmental organizations. As clearly expressed in Graman v. NASD 3, a 1998 decision of the United States District Court for the District of Columbia:

Every court that has considered the question has concluded that NASD is not a governmental actor. See First Jersey Secs., Inc. v. Bergen, 605 F.2d 690, 698, 699 n. 5 (3d Cir.1979); Shrader v. NASD, Inc., 855 F. Supp. 122, 124 (E.D.N.C.1994), aff'd, 54 F.3d 774 (4th Cir.1995); Cremin v. Merrill Lynch Pierce Fenner & Smith, Inc., 957 F.Supp. 1460, 1468 (N.D.Ill.1997); Datek Secs. Corp. v. NASD, Inc., 875 F.Supp. 230, 234 (S.D.N.Y.1995); First Heritage Corp. v. NASD, Inc., 795 F.Supp. 1250, 1251 (E.D.Mich.1992); Bahr v. NASD, Inc., 763 F.Supp. 584, 589 (S.D.Fla.1991); United States v. Bloom, 450 F.Supp. 323, 330 (E.D.Pa.1978).

[Ed: emphasis supplied]

In recent years entities and individuals are finding themselves increasingly under investigation by both an SRO and a criminal prosecutor; whereas previously, parallel investigations were more likely conducted by an SRO and the SEC. Older cases considered the issue of whether an SRO was acting as the agent of the SEC --- and then questioned whether the SEC's role as a government agency was sufficient to infect federal prosecutors under whose aegis federal criminal charges were brought. More recently we are finding SROs accused of directly acting in concert with or at the behest of state or federal prosecutors, with less emphasis on attempting to establish the SEC as a disqualifying intermediary. More dramatically, the SROs themselves are now being characterized as quasi-governmental in nature.

In Marchiano v. NASD4 , the United States District Court for the District of Columbia recently visited the issue of the NASD's role as a "private entity". In Marchiano an NASD member firm's former president sought to enjoin the SRO from pursuing a disciplinary proceeding against him. The Plaintiff alleged that the NASD acted in concert with state prosecutors (who had charged him in a pending 240 count indictment alleging stock manipulation and fraud) and that the SRO was impermissibly planning to provide its disciplinary proceeding materials to the state prosecutors. The NASD argued that it was a private entity, not a state actor. Marchiano countered that the NASD was a quasi-governmental agency acting in concert with the state prosecutors and seeking to coerce him into surrendering his privilege against self-incrimination by threatening him with permanent banishment from the securities industry for failure to testify during the SRO's investigation. In dismissing the complaint against the NASD, the Court cited to Graman as "rejecting the argument that NASD is a 'quasi governmental authority' because of its regulatory duties," and further noted, inter alia:

[T]he court is aware of no case --- and Marchiano has presented none --- in which NASD Defendants were found to be state actors either because of their regulatory responsibilities or because of any alleged collusion with criminal prosecutors.

McCune argues that the sanctions imposed by FINRA conflict with the Eighth and Fourteenth Amendments of the U.S. Constitution because they constitute an excessive fine and violate due process. FINRA is a private actor and not a state actor subject to constitutional requirements. See D.L. Cromwell Invests., Inc. v. NASD Regulation, Inc., 279 F.3d 155, 161-62 (2d Cir. 2002) (holding that NASD, FINRA's predecessor, was not a state actor and thus was not subject to the requirements of the Fifth Amendment); Desiderio v. Nat'l Ass'n of Sec. Dealers, Inc., 191 F.3d 198, 206-07 (2d Cir. 1999) (rejecting plaintiff's claim that NASD violated her rights under the Fifth and Seventh Amendments because NASD was a private actor, not a state actor

Part I:  Are judicial findings of quasi-governmental status for the SROs inconsistent and unfair? (RRBDlaw.com, September 4, 2001)

Part II: Of quasi-horses, quasi-donkeys, quasi-governmental entities, and self-regulatory organizations (RRBDlaw.com, November 2001)

Part III: Is it time to replace Wall Street's "self-regulation" with "private sector regulation?" (RRBDlaw.com, February 2002)

In fact, the internal appeals and administrative-review processes created by the Exchange Act confirm that no private right exists. Those avenues of relief satisfy the Exchange Act's requirement that SROs "provide a fair procedure for the disciplining of members and persons associated with members," and that they "adopt rules establishing an administrative process for disputing the accuracy of information provided in response to inquiries" about affiliated persons. See 15 U.S.C. § 78o-3(b)(8), (i)(3).

(a) Registration; application

An association of brokers and dealers may be registered as a national securities association pursuant to subsection (b), or as an affiliated securities association pursuant to subsection (d), under the terms and conditions hereinafter provided in this section . . .

(b) Determinations by Commission requisite to registration of applicant as national securities association

An association of brokers and dealers shall not be registered as a national securities association unless the Commission determines that

. . .

(4) The rules of the association assure a fair representation of its members in the selection of its directors and administration of its affairs and provide that one or more directors shall be representative of issuers and investors and not be associated with a member of the association, broker, or dealer.

. . .

(8) The rules of the association are in accordance with the provisions of subsection (h) of this section, and, in general, provide a fair procedure for the disciplining of members and persons associated with members, the denial of membership to any person seeking membership therein, the barring of any person from becoming associated with a member thereof, and the prohibition or limitation by the association of any person with respect to access to services offered by the association or a member thereof.

Chief Executive Officer of FINRA;

12 Public Governors;

1 Floor Member Governor;

1 Independent Dealer/Insurance Affiliate Governor;

1 Investment Company Affiliate Governor;

3 Small Firm Governors;

1 Mid-Size Firm Governor; and

3 Large Firm Governors

Small Firm: 1 to 150 registered representative

Mid-Size Firm: 151 to 499 registered representatives

Large Firm: 500 or more registered representative

As of close of business on Monday, May 22, 2017, the number of FINRA small firms was 3,455, and the number of large firms was 180.

Although a person regulated by an SRO might find the prescribed remedies incapable of fully assuaging the reputational harm he suffered as a result of the SRO's regulatory and disciplinary conduct, he chose to accept those limitations on recovery by affiliating himself with an SRO-governed firm.

• FINRA
• SEC
• Schrodinger Cat
• Quasi Governmental
• Solomon
• Turbeville
• BrokeAndBroker
• Bill SInger