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Scottsdale Capital Advisors Corp. v. Financial Industry Regulatory Authority

United States District Court, District of Columbia

July 16, 2019




         Jack Dempsey once observed that “the best defense is a good offense.” In boxing, perhaps, but not always in litigation. This case proves the point.

         For the past decade, Arizona-based securities brokerage Scottsdale Capital Advisors has been in the cross-hairs of its regulator, the Financial Industry Regulatory Authority (“FINRA”). FINRA has fined, sanctioned, and censured Scottsdale and its officers multiple times for a host of violations involving Scottsdale's dealings in unregistered penny stocks. Scottsdale has vigorously defended itself against these actions, complaining that FINRA has unfairly targeted its segment of the securities industry. It has also gone on offense by suing FINRA in federal court. Its most recent suit failed in the District Court for the District of Maryland and then at the Fourth Circuit Court of Appeals for lack of subject-matter jurisdiction. Scottsdale now turns to this Court.

         Scottsdale's newest claim is not a precise mirror of its previous one. Here, it sues FINRA for alleged breaches of the membership agreement Scottsdale entered when joining the organization. But while Scottsdale brings an ostensible breach of contract claim, this Court's jurisdiction turns on the substance of that claim rather than the label affixed to it. Examining the substance, Scottsdale's allegations are all intertwined with FINRA's governance and regulatory decisions, which Congress has mandated be challenged administratively and reviewed by appellate courts. So, different label, same result: This Court lacks the power to hear Scottsdale's claims and will dismiss the case in its entirety.

         I. Background

         A. Regulatory Background

         The Securities Exchange Act of 1934 (“Exchange Act”) authorizes the Securities and Exchange Commission (“SEC”) to register self-regulatory organizations (“SROs”). See 15 U.S.C. § 78o-3(a). Pursuant to that authority, the SEC registered FINRA, a non-profit membership corporation comprised of financial brokers and dealers.[1] FINRA “promulgates rules to enforce broker-dealer compliance with the Exchange Act, ‘the rules and regulations thereunder . . . and the rules of the association.'” Scottsdale Capital Advisors Corp. v. FINRA (“Scottsdale I”), 844 F.3d 414, 417-18 (4th Cir. 2016) (quoting 15 U.S.C. § 78o-3(b)(2)). FINRA “must maintain rules that . . . ‘remove impediments to . . . a free and open market and a national market system, and . . . protect investors and the public interest,' while permitting neither ‘unfair discrimination between customers, issuers, brokers, or dealers' . . . nor the imposition of ‘any burden upon competition not necessary or appropriate in furtherance of the purposes' of the Act.” Domestic Secs., Inc. v. SEC, 333 F.3d 239, 242 (D.C. Cir. 2003) (quoting 15 U.S.C. § 78o-3(b)(6), (9)). All rules promulgated by FINRA must be approved by the SEC and must be consistent with the Exchange Act. 15 U.S.C. §§ 78o-3(b)(6), 78s(b)(2)(C). The SEC also has power to amend any existing FINRA rule to ensure that it comports with the purposes and requirements of the Exchange Act. Id. § 78s(b)(1), (c).

         FINRA also has enforcement powers. It operates as a “‘quasi-governmental agency' authorized ‘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.'” North v. Smarsh, Inc., 160 F.Supp.3d 63, 72 (D.D.C. 2015) (quoting NASD v. SEC, 431 F.3d 803, 804 (D.C. Cir. 2005)) (alteration in original). When FINRA believes a member has violated any of its rules, it can initiate a disciplinary proceeding against the member through a Hearing Panel and impose sanctions on violators. See 15 U.S.C. § 78o-3(h).

         The Exchange Act also sets out the process by which members can challenge FINRA's disciplinary decisions. First, a member firm can appeal a FINRA Hearing Panel decision to the National Adjudicatory Council (“NAC”), a FINRA Committee. North, 160 F.Supp.3d at 72. The NAC can affirm, modify, or reverse a decision. Id. If the NAC affirms a FINRA decision, the member firm can file an Application for Review of the decision with the SEC. See 15 U.S.C. § 78s(d). If the SEC affirms that decision, member firms still have one final option: appeal to the appropriate circuit court of appeals. See id. § 78y(b).

         B. Scottsdale's Allegations

         The following allegations are drawn from Scottsdale's Complaint. As it must at this stage in the litigation, the Court assumes the truth of well-pleaded factual allegations, though it need not accept a plaintiff's legal conclusions. See, e.g., Am. Nat'l Ins. Co. v. FDIC, 642 F.3d 1137, 1139 (D.C. Cir. 2011) (citations omitted). “Virtually all firms in the purchase and sale of securities must be members of FINRA.” Compl. ¶ 15. Scottsdale, as one such firm, has been a member of FINRA since 2002. Id. ¶ 7. When it joined, Scottsdale entered into FINRA's standard membership agreement. Id. ¶ 28. FINRA describes the membership agreement as a “contractual relationship between [a member] and FINRA.” Id. (citation omitted). FINRA's ByLaws are incorporated into the membership agreement, which expressly requires compliance with those By-Laws. Id. ¶ 29.

         Scottsdale alleges that FINRA has violated its By-Laws and the Exchange Act in several ways. First, the composition of its board. The Exchange Act requires that FINRA “assure fair representation of its members” and “not impose any burden on competition not necessary or appropriate in furtherance of the purposes of” the Act. 15 U.S.C. § 78o-3(b)(4), (9); see Compl. ¶ 31. Scottsdale contends that FINRA has violated this covenant by permitting members to elect only seven of its twenty-three governors. Compl. ¶ 34. Aggravating that situation, according to Scottsdale, is the fact that only three of those seven seats can be filled by governors from “small firms” like Scottsdale. Id.

         Second, the use of internal guidance. Scottsdale alleges that FINRA has promulgated guidance containing its interpretation of SEC rules and regulations as well as federal statutes. Id. ¶ 38; see also id. ¶ 39 (including example in which FINRA guidance “directly target[ed] transactions involving microcap and low-priced securities”). Per Scottsdale, this guidance is not issued pursuant to the procedures articulated in FINRA's By-Laws, nor does it conform to the requirements of the Exchange Act. Id. ¶ 38. Nevertheless, Scottsdale claims, FINRA has taken the view that the guidance is binding on its members, with disciplinary consequences for failure to comply. Id. Scottsdale offers several examples where FINRA has “wielded this guidance against its members, ” id. ¶ 41, pursuing disciplinary actions “based on its dim view of the microcap and low-priced securities market segment, ” id. ¶ 42. As Scottsdale frames it, “FINRA's crusade against the microcap and low-priced securities market has directly impacted Scottsdale, which engages in that industry.” Id. ¶ 48. Specifically, it complains that FINRA has targeted it for “examinations, extensive document requests, and prosecutions, and sought to levy fines against it for its day-to-day business activities.” Id.

         Third, ultra vires enforcement. Scottsdale alleges that FINRA has engaged in improper enforcement of FINRA Rule 2010. See id. ¶¶ 52-61. That rule provides that each FINRA member “in the conduct of its business[] shall observe high standards of commercial honor and just and equitable principles of trade.” FINRA R. 2010; see also Compl. ¶ 52. The SEC approved that rule in 2008 on the basis of Section 15A(b)(6) of the Exchange Act, which requires SROs to “promote just and equitable principles of trade.” Compl. ¶ 53. The Complaint alleges that, in disciplinary proceedings against Scottsdale, FINRA “propounded a contrary interpretation of FINRA Rule 2010” when it accused Scottsdale of violating not the 1934 Exchange Act, but a section of the ...

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