Protecting Your Bottom Line from the Cost of National Association of Securities Dealers and FINRA Investigations

September 27, 2012

When self-regulatory organizations (“SRO”), such as the Financial Industry Regulatory Authority (“FINRA”), commence an investigation or proceeding, member firms are typically concerned with the financial impact that both the defense costs and any ultimate payment obligation will have on their bottom line.  With the United States Second Circuit Court of Appeal’s decision in Fiero v. Financial Industry Regulatory Authority, Inc., 660 F.3d 569 (2d Cir. 2011) that SRO fines are not judicially enforceable, member firms may be able to obtain balance sheet protection from these proceedings through insurance coverage. 

Historically, Errors & Omissions (“E&O”) or Director & Officer (“D&O”) insurance policies excluded coverage for “fines or penalties imposed by law.”  Since Fiero precludes SROs from judicially enforcing their fines, these fines can no longer be “imposed by law” and member firms have strong arguments that insurers must provide indemnity and reimburse them for any defense costs incurred.  

This access to insurance coverage is significant for multiple reasons:  it not only reduces the financial impact of SRO investigations and proceedings, but also negates a significant point of leverage that SROs have when negotiating settlements with member firms.

I.  Overview of Fiero and Its Progeny

In Fiero, the Second Circuit faced the question of whether SROs, such as FINRA, can judicially enforce the collection of fines against member firms.  SeeFiero, 660 F.3d at 574.  The Second Circuit ruled that SROs do not have the ability to judicially enforce their fines under the Securities Exchange Act of 1934 (the “Exchange Act”).  Id. In reaching this conclusion,the Second Circuit noted that Congress intentionally did not provide SROs access to the judicial system to enforce their fines:  Congress “was well aware of how to grant an agency access to the courts to seek judicial enforcement of specific sanctions, including monetary penalties.”  Id. at 575.^[1]

Since Fiero, at least one other court has extended the holding in Fiero to preclude an SRO from judicially enforcing its disciplinary fines.  See generallyNasdaq OMX PHLX, Inc. v. Pennmont Securities, 2012 WL 2877607 (Pa. Sup. Ct. July 16, 2012) (“Pennmont”).  In Pennmont, Nasdaq OMX PHLX, Inc. (“Nasdaq”) sought to judicially enforce a fine imposed under Exchange Rule 651 that its member firm – Pennmont Securities – refused to pay.  Id. at 2-4.  In ruling that Nasdaq could not commence a private action to collect on its disciplinary fine, the Pennsylvania Superior Court performed an analysis similar to that of the Second Circuit.  Id. at *16. 

Notably, the court held that Congress “was aware it could authorize judicial enforcement of monetary penalties imposed via disciplinary rules and regulations, including Rule 651,” but Congress “opted to remain silent about whether courts could enforce such monetary penalties.”  Id.  Thus, the court concluded that “we will not imply a private right of action to other sections of the Exchange Act that are silent.”  Id.

II.  Impact of Fiero on Insurance Coverage for SRO Investigations

A significant number of articles have been written about Fiero, noting that the decision “will not have a significant impact on member firms because the prospect of expulsion from the industry provides sufficient incentive to pay monetary penalties imposed by FINRA.”  See Second Circuit Rules FINRA Has No Power to Enforce Disciplinary Fines in Court, Nader H. Salehi (Oct. 6, 2011); see also Second Circuit Court of Appeals Rules FINRA Lacks Authority to Sue to Collect Fines, Joseph D. Simone (Oct. 17, 2011).  Fiero does, however, provide member firms an opportunity to access insurance coverage to protect against the costs of SRO investigations and proceedings.

D&O and E&O policies typically provide coverage for a “claim” (a “written notice, including service of suit or demand for arbitration, received by one or more insureds asking for money or services”) arising out of a “wrongful act” (“any negligent act, error, or negligent omission to which this insurance applies”).  Further, D&O and E&O policies typically provide a duty to defend if the suit seeks damages for loss “to which this insurance applies”: 

We will pay those sums that the insured becomes legally obligated to pay as damages . . . because of negligent acts or omissions committed in the scope of duties as a director or officer . . . which [occur] during the policy period to which this insurance applies. We will have the . . . duty to defend any ‘suit’ seeking those damages.

D&O and E&O policies, however, typically carve out fines from coverage:  “‘Loss’ shall not include . . . Fines or penalties imposed by law.” 

Insurers have argued that they have no obligation to indemnify their insureds for SRO fines and defense costs because any “fines or penalties” would be “imposed by law.”  However, with the issuance of Fiero and Pennmont, member firms have strong arguments that such “fines or penalties” cannot be “imposed by law.”  SeeFiero, 660 F.3d at 574; Pennmont, 2012 WL 2877607, at *16-17.  Moreover, member firms are in a much better position to argue that insurers are obligated to reimburse the member firms for defense costs until such time as a court concludes that SRO fines may be “imposed by law.”  See Fed. Ins. Co. v.Kozlowski, 18 A.D.3d 33 (N.Y. App. Div. 2005); Am. Home Assur. Co. v. Port Auth. of N.Y. & N.J., 66 A.D.2d 269, 278 (N.Y. App. Div. 1979). 

 III.  Member Firms Should Be Proactive In Determining Whether Insurance Coverage is Available To Avoid Out-of-Pocket Expenses

Given Fiero and Pennmont, member firms (especially in-house counsel) should act proactively to determine whether their current E&O or D&O insurance policies provide indemnity for SRO fines and reimbursement of defense costs.  In the event they do not, consider obtaining such coverage when renewing insurance policies.

In addition, if an SRO commences an investigation or proceeding, member firms should promptly provide notice of a potential claim to their insurers.  Failure to provide prompt notice may jeopardize a member firm’s insurance recovery.  Additionally, member firms should notify the insurer regarding the identity of the lawyers who will represent them in the underlying SRO investigation or proceeding.  Member firms should also provide regular updates of the activity in the underlying claim. 

Member firms need to be aware that the wheels of insurance are often slow to turn, and if an insurer denies coverage, that is not the last word.  Member firms should be ready to retain insurance coverage counsel to help guide them through the insurance process.