Broker weighs appeal in constitutional challenge of FINRA powers

The wave pushing back securities regulators' enforcement powers is showing some signs of breaking before it reaches the shore.

Judge John Murphy of the U.S. District Court for the Eastern District of Pennsylvania earlier this month dismissed an embattled broker's legal challenge of the Financial Industry Regulatory Authority's use of internal disciplinary procedures. Like a similar case involving the SEC, the suit filed on behalf of a broker named D. Allen Blankenship argued FINRA's in-house proceedings violate defendants' constitutional right to a jury trial. 

But rather than take up those arguments, Judge Murphy dismissed the challenge on technical grounds. In a memorandum explaining his decision, Murphy noted FINRA's disciplinary procedures don't "foreclose" Blankenship's ability to seek satisfaction from the courts. If Blankenship lost his initial case with FINRA, he could file appeals first with FINRA's own National Adjudicatory Council and then with the SEC, Murphy wrote.

If the things still didn't go his way at those two levels, he could ultimately turn to federal appellate courts. In other words, Blankenship brought his challenge in the wrong venue.

"We lack subject matter jurisdiction over Mr. Blankeship's collateral attack on his FINRA proceeding," Murphy wrote. "Mr. Blankenship will have to pursue his theory on direct appeal."

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FINRA last year accused Blankenship of making unsuitably frequent mutual fund trades. Those charges came more than four years after Blankenship, a broker with 27 years of industry experience and 11 firms to his name, was fired by King of Prussia, Pennsylvania-based Independent Financial Group over allegations that he had failed to ensure clients were receiving certain benefits from mutual fund investments.

Next steps

Blankenship's lawyer, Dochtor Kennedy of Westminster, Colorado-based AdvisorLaw, said he's now weighing possible next steps in the case. He said he sees Judge Murphy's ruling as a pretty clear signal his client could have a strong case before the SEC.

He didn't know yet, though, if he'd file a formal appeal in court. 

"Still contemplating," Kennedy wrote in an email.

Blankenship's challenge of FINRA sought to build on a U.S. Supreme Court ruling from June finding that the Securities and Exchange Commission couldn't handle alleged fraud cases internally but instead had to present them before courts. His suit tried to raise similar constitutional questions about FINRA's own proceedings.

Mounting challenges to regulatory authority

Blankenship's suit comes amid a series of challenges looking at regulators' authority to enforce industry rules internally rather than having to turn to the court system. In SEC v. Jarkesy — the decision Blankenship pointed to in his challenge of FINRA's procedures — the Supreme Court held that the SEC had been violating defendants' constitutional right to a jury trial with its former practice of bringing fraud allegations before in-house tribunals known as administrative law judges.

With the Supreme Court ruling against the SEC in that case, predictions have been running high that other regulatory bodies' authority would soon be challenged on similar grounds. Blankenship's suit isn't the only recent case to cite the high court's Jarkesy decision as a precedent.

In Rev. Father Emmanuel Lemelson v. SEC — a case quickly dubbed by many Jarkesy 2.0 — an ordained Greek Orthodox priest and hedge fund advisor questions regulators' authority to use internal procedures to bar him from the securities industry. Lemelson and his firm, Lemelson Capital Management, were accused by the SEC in 2018 of running a "short and distort" scheme to run down the stock price of a pharmaceutical firm after he had placed bets against the company.

The SEC had sought more than $2.6 million in penalties and disgorgement. But in 2021, a Massachusetts federal jury knocked the civil penalty down to $160,000 after finding Lemelson had made only three factual misstatements.

Now, according to the suit, the SEC has turned to in-house procedures in its continued attempt to oust him from the industry. As in the Jarkesy case, Lemelson is accusing regulators of trying to do an end run around his constitutionally guaranteed right to a jury trial.

Lemelson's lawyer, Russ Ryan of the New Civil Liberties Institute, called the case "a logical extension of Jarkesy, although it could have been brought before Jarkesy or even if Jarkesy had gone the other way."

"The main argument is that the SEC is inherently biased in a situation like this," said Ryan, whose group has successfully challenged the SEC's authority in other cases. "Lemelson should get a jury trial because the whole adjudication is tainted. The SEC has been in an adversarial relationship with Father Lemelson for the better part of the last decade."

Far-reaching consequences

The Jarkesy decision only limited the SEC's authority to use internal procedures to obtain civil penalties in fraud cases — leaving open the possibility that it could still seek things like disgorgement and restitution outside of courts. Benjamin Edwards, a professor of law at the William S. Boyd School of Law at the University of Nevada-Las Vegas, said a ruling against the SEC in the Lemelson suit could have much farther-reaching consequences.

He likened the situation to a scene in the movie Ghostbusters in which an Environmental Protection Agency officer orders the shutdown of a containment system holding the supernatural beings that had been terrorizing the city for the past few weeks. Like the ghosts in the film, formerly barred brokers could operate freely again if a court decided the SEC had exceeded its authority when it booted them from the industry.

The result, Edwards said, would be "a mess."

"With people who are already barred, they could be alleging the bar should be enjoined because it was unconstitutional when it was done and how it was done," he said. "So you could be looking at everyone with a lifetime bar suddenly being free to fleece your grandma."

Separately, Alpine Securities, a firm that has been under an expulsion order since March 2022 for allegedly saddling clients with unreasonably high fees, is challenging FINRA's basic structure in federal appeals court in Washington, D.C. Alpine's legal challenge questions why a private organization like FINRA should have broad enforcement powers over the securities industry. A decision in that case is still pending.