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Fiero v. Financial Industry Regulatory

April 2, 2009


The opinion of the court was delivered by: VICTOR Marrero, United States District Judge


Plaintiffs John J. Fiero ("Fiero") and Fiero Brothers, Inc. ("Fiero Brothers") (collectively the "Fieros") brought this action against defendant Financial Industry Regulatory Authority, Inc. ("FINRA") seeking a judgment declaring that FINRA cannot recover financial penalties that FINRA imposed on the Fieros following a disciplinary proceeding. FINRA counterclaims to collect those same penalties. Now before the Court are cross-motions to dismiss the parties' respective complaints pursuant to Federal Rule of Civil Procedure 12(b)(6) ("Rule 12(b)(6)").


Fiero Brothers was a member of the National Association of Securities Dealers ("NASD") and a broker-dealer registered with the Securities and Exchange Commission ("SEC"). Fiero was the sole registered representative of Fiero Brothers. The Fieros' membership in NASD and activities in the securities industry subjected them to the regulation and discipline of NASD.

FINRA is a private non-profit Delaware Corporation and a self-regulatory organization ("SRO") registered with the SEC as a national securities association pursuant to the Maloney Act of 1938. See 15 U.S.C. § 78o-3, amending the Securities Exchange Act , 15 U.S.C. § 78a-§ 78jj ("Exchange Act"). NASD changed its corporate name to FINRA on July 30, 2007. Throughout the period of the Fieros' membership, FINRA was still known as NASD.*fn2


Because FINRA is an SRO, it straddles the line between a public and a private entity. The D.C. Circuit recently described FINRA's complex role:

By virtue of its statutory authority, NASD 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 Securities and Exchange Commission regulations issued pursuant thereto.

National Ass'n of Securities Dealers v. Security and Exch. Comm'n, 431 F.3d 803, 804 (D.C. Cir. 2005) (internal citations omitted); see also 15 U.S.C. § 78o-3(b)(7).

As part of FINRA's mandate, it has the responsibility to "promulgate and enforce rules governing the conduct of its members." Barbara v. New York Stock Exchange, 99 F.3d 49, 51 (2d Cir. 1996) (citing 15 U.S.C. § 78f(b), 78s(g)) (discussing the role of an SRO). In fact, federal law prohibits the SEC from approving an SRO until it determines that:

The rules of the association provide that ... its members and persons associated with its members shall be appropriately disciplined for violation of any provision of this chapter, the rules or regulations thereunder, . .. or the rules of the association, by expulsion, suspension, limitation of activities, functions, and operations, fine, censure, being suspended or barred from being associated with a member, or any other fitting sanction.

15 U.S.C. § 78o-3(b)(7). In exercising these powers, the Exchange Act also requires SROs to "provide a fair procedure for the disciplining of members." 15 U.S.C. § 78o-3(b)(8). Further, because FINRA is a quasi-governmental agency, federal law subjects FINRA to extensive oversight. For example, "the SEC has ... the responsibility to approve or reject any rule, practice, policy, or interpretation proposed by an SRO." DL Capital Group, LLC v. Nasdaq Stock Market, Inc., 409 F.3d 93, 95 (2d Cir. 2005); see also 15 U.S.C. § 78s.

NASD's rules are embodied in its Rules and Regulations. NASD disciplinary procedures can be found in Rules 9100-9800 ("NASD Rules").*fn3 The NASD Rules require specific procedures for formulating the a complaint, providing service of process, discovery, and the other attributes that epitomize our notion of fair process. See NASD Rules 9211-9290. The NASD Rules further allow for appeal of a NASD ruling to the National Adjudicatory Council ("NAC"), see Rule 9311, and discretionary review by the NASD Board, see Rule 9351. Finally, a member may appeal to the SEC for review of an NAC ruling and may then appeal the SEC's decision to the appropriate federal Court of Appeals. See 15 U.S.C. § 78s(d)(2), § 78y(a). If the member appeals an imposed fine to the SEC, and the SEC affirms the fine, the SEC is statutorily authorized to seek enforcement of the fine in federal court. See 15 U.S.C. § 78u(e). Even if the member does not request such review, the Exchange Act requires FINRA to report any disciplinary decisions to the SEC and the SEC can review any decision on its own initiative. See 15 U.S.C. § 78s(d)(1),(2).


The controversy in this action began when NASD commenced a disciplinary proceeding against the Fieros on February 6, 1998 for allegedly executing a "bear raid" of short selling in order to manipulate the price of certain securities. See Department of Enforcement v. Fiero, Complaint No. CAF980002, 2002 WL 31476976, October 28, 2002. On December 6, 2001, the NASD hearing panel issued a decision concluding that the Fieros had violated § 10(b) of the Exchange Act, SEC Rule 10b-5, and NASD conduct rules. See id. at 1. The Fieros appealed this decision to the NAC, which affirmed on October 28, 2002. In addition to barring John Fiero from associating with any NASD member, and expelling Fiero Brothers, Inc. from NASD membership, the NAC affirmed the $1,000,000 fine and $10,809.25 in costs imposed on the Fieros jointly and severally. The Fieros did not pursue their appeal to the SEC and the NAC decision became final.


On December 22, 2003, NASD filed a breach of contract action in New York state court seeking to collect the fines and costs imposed on the Fieros in the disciplinary proceeding. See National Ass'n of Sec. Dealers, Inc. v. Fiero, No. 04 Civ. 102755, 2006 WL 5111058 (N.Y. Sup. Ct. May 11, 2006). The trial court implicitly rejected the Fieros' contentions that NASD lacked the power to collect the fines or that NASD was time barred by the New York state statute of limitations for recovering arbitration awards. The trial court granted NASD's motion for summary judgment on its contract claim. The First Department unanimously affirmed. See National Ass'n of Sec. Dealers, Inc. v. Fiero, 827 N.Y.S.2d 4, 5 (App. Div. 1st Dep't 2006).

The Fieros appealed and the New York Court of Appeals vacated the judgment and dismissed FINRA's claim for lack of subject matter jurisdiction. See Financial Indus. Reg. Auth., Inc. v. Fiero, 882 N.E.2d 879, 882 (N.Y. 2008). The Court of Appeals concluded that Section 27 of the Exchange Act, 15 U.S.C. § 78aa ("Section 27"), vested exclusive jurisdiction to "enforce a penalty imposed on the Fieros as a result of disciplinary proceedings provided for by the Securities Exchange Act for violations of the Securities Exchange Act and its implementing rules in the federal courts." Id. at 17. After being dismissed from New York State court, the parties turned to this Court.

II. Discussion

A. Jurisdiction

1. "Arising Under" Jurisdiction The Fieros seek relief under the Declaratory Judgment Act (the "DJA"), 28 U.S.C. § 2201(a). The DJA, however, does not itself confer subject matter jurisdiction on federal courts.

Instead, the DJA "merely expands the remedies available in the district courts without expanding their jurisdiction." Duke Power Co. v. Carolina Env't Study Group, Inc., 438 U.S. 59, 98 (1978) (Rehnquist, J., concurring). Thus, "there must be an independent basis of jurisdiction before a district court may issue a declaratory judgment." Correspondent Servs. Corp. v. First Equities Corp., 442 F.3d 767, 769 (2d Cir. 2006). As an independent basis for jurisdiction, the Fieros assert that this action arises under the laws of the United States. See 28 U.S.C. § 1331. FINRA agrees that these claims arise under the laws of the United States.

While both parties agree that federal jurisdiction exists, "it is well settled that lack of federal jurisdiction may be raised for the first time on appeal, even by a party who originally asserted that jurisdiction existed, or by the Court sua sponte." City of Rome v. Verizon Commc'ns, Inc., 362 F.3d 168, 174 (2d. Cir. 2004) (quoting United States v. Leon, 203 F.3d 162, 164 n. 2 (2d Cir. 2000)).

The parties assert that the claims arise under the Exchange Act and the rules promulgated thereunder. Section 27 confers exclusive jurisdiction on the federal courts for violations of the Exchange Act:

The district courts of the United States and the United States courts of any Territory or other place subject to the jurisdiction of the United States shall have exclusive jurisdiction of violations of this chapter or the rules and regulations thereunder, and of all suits in equity and actions at law brought to enforce any liability or duty created by this chapter or the rules and regulations thereunder.

15 U.S.C. § 78aa.

As discussed above, while the Exchange Act and the regulations promulgated under it do empower FINRA to operate as an SRO, neither the Exchange Act nor the SEC directly administers the disciplinary proceedings or imposes the fines. Instead, FINRA conducts those activities as a private corporation and binds its members through contract. Therefore, it is the contractual relationship between FINRA and the Fieros that creates FINRA's right to collect, not federal statute. This Court, therefore, must determine whether the dispute underlying the declaratory judgment action, FINRA's claims for breach of contract, arises under the laws of the United States. In undertaking this inquiry, it must be the claim itself, and not any federal defenses that might be raised, which implicate federal questions. See Louisville & Nashville R. Co. v. Mottley, 211 U.S. 149, 152 (1908).

Courts have used two tests to determine whether an action presents a federal question. See West 14th St. Commercial Corp. v. 5 W. 14th Owners Corp., 815 F.2d 188, 192 (2d Cir. 1986). First, federal question jurisdiction exists when federal law creates the cause of action. See Franchise Tax Bd. v. Constr. Laborers Vacation Trust, 463 U.S. 1, 8-9 (1983); American Well Works Co. v. Layne & Bowler Co., 241 U.S. 257, 260 (1916). The Supreme Court has cautioned that the vast majority of cases falling within the statutory grant of federal question jurisdiction are covered by this test, see Merrell Dow Pharmaceuticals Inc. v. Thompson, 478 U.S. 804, 808 (1986), while recognizing that the test "has been rejected as an exclusionary principle," Franchise Tax Bd., 463 U.S. at 9, in that it does not describe which cases are beyond district court jurisdiction. This test can best be understood as involving an inquiry into whether the right or remedy that plaintiff is asserting is strictly a function of substantive state law, that is, whether the underlying cause of action is created by state law and, therefore, the case falls outside of federal jurisdiction. If this proposition holds, on looking at the elements of the state cause of action, none will explicitly require application of federal law, although collateral questions or interpretations implicating federal law may also be involved that could affect, even if not necessarily dispose of, the state law action. For example, if such a case were to go to a jury, the jury would be instructed only on the substantive content of state law that established the rights and remedies for liability upon which the action depends, as well as applicable defenses.

Because FINRA's substantive claim is not created by federal law, subject matter jurisdiction cannot be based upon the first test. See Franchise Tax Bd., 463 U.S. at 8-9; American Well Works, 241 U.S. 257, 260 (1916). FINRA's claims are contractual in nature, and federal law - whether it be preemption, statute of limitations, or lack of statutory and regulatory authority - is primarily implicated in the defenses asserted to the contractual claims. The second test posits that a case may also arise under federal law when "some substantial, disputed question of federal law is a necessary element" of a state claim in a well-pleaded complaint, and thus an adjudication of the merits of the underlying dispute, and the existence, or not, of a right or remedy asserted, depends on the interpretation or application of federal law. Franchise Tax Bd., 465 U.S. at 13. This sliver of jurisdiction "captures the commonsense notion that a federal court ought to be able to hear claims recognized under state law that nonetheless turn on substantial questions of federal law, and thus justify resort to the experience, solicitude, and hope of uniformity that a federal forum offers on federal issues." Grable & Sons Metal Prod., Inc. v. Darue Eng'g & Mfg., 545 U.S. 308, 312 (2005).

As the Supreme Court articulated the inquiry, a case may be said to arise under federal law "where the vindication of a right under state law necessarily turn[s] on some construction of federal law." Franchise Tax Bd., 463 U.S. at 9 (emphasis added). However, this statement "must be read with caution." Merrell Dow, 478 U.S. at 809 (noting that while the central issue in Franchise Tax Board was the meaning of a federal statute, the Court nevertheless "concluded that federal jurisdiction was lacking" there). "[C]ourts have found that removal to federal court is proper where the state action simply provides the vehicle for 'the vindication of rights and ... ...

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