September 4, 2001
Are judicial findings of quasi-governmental status for the SROs
inconsistent and unfair?
By Bill Singer
Following on the heels of last year's high-tech/Internet stock collapse,
public customers have been filing complaints in growing numbers against issuers,
analysts, investment bankers, broker-dealers ("BDs"), and registered
persons. A byproduct of this discontent is increased scrutiny of Wall Street by
Congress and the various industry regulators. Accordingly, I find myself more
involved with matters before the self-regulatory organizations ("SROs"),
as BDs, their management, and their employees are receiving increasing numbers
of demands to produce documents and give testimony. Although it may seem
comforting to view SRO regulatory practice as an isolated, esoteric discipline
without impact beyond the registered entities and individuals subject to the
respective jurisdiction, such a perspective is myopic. The ramifications of such
investigations reach far beyond the walls of any given member firm and
frequently affect pending shareholder lawsuits, consumer-initiated and
intra-industry arbitrations, grand jury investigations, and subsequent criminal
Unfortunately, to the unfamiliar practitioner, SRO investigative practice may be
more than arcane --- it may be troubling and, at times, infuriating. Significant
procedural policies are rarely memorialized. Disputes concerning on-site
examinations or On-the-Record interviews ("OTRs") are usually resolved
by a Staff member's arbitrary determination. When one raises a legitimate
protest and requests a citation to whatever rule or regulation supports the
Staff's position, the reply is frequently, "It's not codified, we don't
have to put it in writing, Staff controls the record, and you're interfering
with the investigation."
In recent years we have seen such new phenomena as electronic communications
networks ("ECNs"), direct-access trading platforms, and discount,
online broker-dealers. Similarly, we have seen dramatic inroads into the
securities industry by organized crime and have witnessed more sophisticated
financial fraud. And while it is fair to say that the SROs continue to play an
important role in investigating marketplace misconduct, it is equally true that
in some sense that role has diminished --- to the extent that the ultimate forum
for resolving serious fraud is more frequently at the Securities and Exchange
Commission ("SEC") or within the criminal justice arena.
two decades on Wall Street, during which time I have served as a regulatory
attorney with the American Stock Exchange and the NASD, as in-house counsel to
the industry, and more recently as a private practitioner, I have had an
opportunity to observe self-regulation from both sides of the table. Now, with a
new Presidential Administration, with a new SEC Chairman, and with our stock
markets roiling in the face or an uncertain economy, I believe we must
reappraise the system of self-regulation by asking three questions:
I. Are judicial findings of a quasi-governmental status for the SROs inconsistent and
II. Is the piecemeal incorporation of criminal procedure into the SROs' civil,
regulatory process inappropriate in the absence of the higher criminal standard
for the burden of proof and attendant constitutional safeguards?
III. Must self-regulation be dismantled or can it be preserved through the
implementation and codification of due process guarantees during investigations
and pre-hearing practices?
Solomon Splits the Baby
More than a quarter of a century ago in the United States v. Solomon1, the Second
Circuit ruled that SROs are private investigative organizations and do not
trigger the self-incrimination rights attributable to government entities. In Solomon, a NYSE member firm notified the NYSE in mid-April 1973 of potentially
significant books and records problems. The NYSE promptly investigated the firm
and advised the SEC of the probable violations. On May 15, 1973 the SEC entered
an Order of Investigation. On May 16, 1973 the SEC served a subpoena on the NYSE
for production of all Solomon investigatory material. On May 17, 1973 Alan C.
Solomon, an officer and director of the member firm, was summoned to testify
before the NYSE's Department of Member Firms.
Under the then existing NYSE's
Constitution, a failure to testify could result in the non-cooperating party
being "suspended or expelled." Solomon appeared at the interrogation,
did not claim any privilege against self-incrimination, and answered the NYSE's
questions. Subsequently, the member firm was placed in receivership and Solomon
(as well as four other officers/directors) was indicted in July 1973. Solomon's
NYSE testimony was introduced during his criminal trial and he was subsequently
found guilty on one count of creating and maintaining false books and records.
Solomon's sole point on appeal was the use before the grand jury and at trial of
his NYSE transcript (he had previously sought to have the testimony suppressed).
Essentially, Solomon argued "interrogation by NYSE must be deemed the
equivalent of interrogation by the United States because the Exchange has become
in effect the arm of the Government in administering portions of the Securities
In denying his appeal, the Court declined to deem the NYSE
an agent of the SEC and held that
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 . . .2"
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,
763 F.Supp. 584, 589 (S.D.Fla.1991); United States v. Bloom, 450 F.Supp. 323,
[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
Consequently, in 2001 a line of cases from Solomon forward has consistently
deemed SROs to be private entities, even to the extent that they lack
quasi-governmental standing. An interesting example of the lengths to which some
courts are prepared to go to sustain a finding of non-governmental,
private-entity status is demonstrated in D.L. Cromwell Investments, Inc. v. NASD5.
In Cromwell the United States District Court for the Southern District of New
York considered a motion for a preliminary injunction, which was brought by
targets/subject of a federal grand jury investigation. Plaintiffs there alleged
that the NASD was seeking to coerce them into testifying before the SRO and
participating in its disciplinary proceedings after they asserted their Fifth
Amendment privileges in the federal investigation. In essence, the Plaintiffs
sought to depict the NASD as an agent of the federal prosecutors. The Court
characterized the Plaintiffs' allegations as follows:
Plaintiffs nevertheless argue the Court should . . . infer that DOE [NASD
Department of Enforcement] is acting as the cat's paw on the government from a
series of circumstances:
Regulation issued Rule 8210 demands to two . . .
plaintiffs for personal financial records shortly after [the plaintiffs
received] Eastern District grand jury subpoenas.
[A]n unidentified FBI agent
is said to have stated that "we are working with the NASD --- they know
exactly what is going on."
[D]uring [NASD] investigational testimony [an
employee] was questioned regarding two documents that plaintiffs "believe'
were seized by the FBI and surmise were not produced by them to Regulation.
[A grand jury] subpoena gave the witness the opportunity to respond by
delivering responsive documents to . . . the NASD Washington office.
Regulation has refused to adjourn the interview until the completion of the
Additionally, the Court noted that NASD Regulation
("NASDR"), the NASD's regulatory arm had formed in 1998 a Criminal
Assistance Prosecution Unit to assist and advise federal/state prosecutors and
that the unit's sole attorney was designated as a Special Assistant United
States Attorney in various districts from time to time. The Court further noted
that the unit's staff is granted access to federal grand jury materials pursuant
to court order. Ultimately, in dismissing Plaintiffs' motion, the Court once
again held that the Fifth Amendment prohibits only governmental action and that
NASD and NASDR are "private entities."6
And this line of cases has now
filtered down into the very jurisprudence of the SROs themselves. On April 30, 2001, NASD Regulation, Inc. determined, in
DOE v. Frank A. Persico7
[t]he Federal Courts have consistently held that the Fifth Amendment claim
against self-incrimination cannot be properly asserted when appearing before a
self-regulatory organization. As explained in the recent federal court decision
in D.L. Cromwell Investments, Inc., et al., v. NASD Regulation, Inc., the Fifth
Amendment privilege does not apply to the NASDR in performing its statutory
mandate, since it is not a government actor. 2001 U.S. Dist. LEXIS 1912 (S. D.
N. Y. February 26, 2001). In D.L. Cromwell, the court held that [t]he Fifth
Amendment prohibits only governmental action. The NASD and [NASD] Regulation are
private entities.... Hence, even if the individual plaintiffs are being
compelled to give evidence against themselves by the threat of NASD sanctions, [NASD]
Regulation's actions raise no Fifth Amendment issue unless it fairly may be said
that its actions are fairly attributable to the government.
This private entity,
non-governmental actor characterization has been adopted by other SROs8.
Wearing two hats: the quasi-governmental chapeau
At first blush it would appear that the issue has been resolved. The NASD, the
NYSE --- SROs as a whole --- are not governmental actors but private entities.
However, in 1998 in Sparta Surgical Corporation v. NASD9, the Ninth Circuit
Court of Appeals considered what civil remedies were available against the NASD
for wrongfully temporarily delisting and suspending trading in a stock on the
opening day of a public offering. The Court found that the SRO was immune from
such a lawsuit and affirmed the lower court's dismissal. The Court reasoned that
[e]xtending immunity when a self-regulatory organization is exercising
quasi-governmental powers is consistent with the structure of the securities
market as constructed by Congress. When Congress considered the burgeoning
over-the-counter market in the 1930s, it was confronted with two alternatives: a
"pronounced expansions" of the SEC, or a system of industry
self-regulation with strong SEC oversight. S. Rep. No. 1455, 75th Cong., 3d.
Sess. 3-4 (1938). Congress chose the latter approach and, with enactment of the
Maloney Act, established a system of "cooperative regulation" . .
.[citing 1 Loss & Seligman, 6 Securities Regulation 2787-90 (3d Ed. 1990).
In 1975, Congress amended the Exchange Act to vest more control in the SEC . . .
[S]elf-regulatory organizations "are intended to be subject to the SEC's
control and have no governmentally derived authority to act independently of SEC
oversight." H.R. Rep NO. 123, 94th Cong., 1st Sess., 48-49 (1975).
Sparta appears to have made a bit of a right turn on the
issue of an SRO's private entity status --- the Court allowed for the existence
of so-called quasi-governmental powers. The Court's analysis is somewhat
provocative in that it talks about quasi-governmental status and cooperative
regulation between the SEC and SROs, and at the same time notes that since 1975
Congress has attempted to solidify the "control" of SROs by the SEC.
So in one breath, the Court swept aside the concept of a completely
non-governmental, private entity; in another breath the Court (perhaps
unwittingly) strengthens the historic "agency" argument by
characterizing the SEC as something akin to either a regulatory partner or a
control-person of the SROs.
Not a private business!?
On the heels of Sparta, the
Ninth Circuit considered Partnership Exchange Securities Company v. NASD10, a
complaint for money damages against the NASD arising from alleged improprieties
attendant to the initiation of disciplinary proceedings against a member firm.
In Partnership Exchange the Court once again affirmed a lower court's dismissal
on the basis of an SRO's absolute immunity. Following a review of its previous
holding in Sparta, the Court reiterated that
[T]he NASD was not acting as a private business, so its actions are protected by
absolute immunity from money damages. . . acts similar to a prosecutor's
preparation "for the initiation of judicial proceedings or for trial"
are entitled to absolute immunity from suits for money damages. Buckley v.
Fitzsimmons, 509 U.S. 259, 273 (1993). The NASD's actions fit under that rubric
. . .
[Ed: emphasis supplied]
Within the context of Fifth Amendment compelled-testimony cases, courts seem
adamant that SROs are private businesses not amenable to government action ---
not even as agents of prosecutors. Within the context of lawsuits for money
damages against SROs, the courts seem equally as adamant that those entities are
quasi-governmental. So which is it? Are SROs private entities capable of
compelling witnesses to waive their Fifth Amendment rights, or are they
quasi-governmental entities absolutely immune from lawsuit when acting in such
capacity --- or are they both?
Simple Logic and Intense Practicality?
consider the recent case of D'Alessio v. NYSE et al11, which combines several
elements addressed separately in the case analyses above. A registered person
sues an SRO (which he also alleges is acting in concert with both a federal
prosecutor and the SEC) for money damages. In December 1999, John R. D'Alessio
("D'Alessio") sought compensatory and punitive damages against the
NYSE and various officers arising from claims of injurious falsehood, fraudulent
deceit and concealment, negligent misrepresentation, and breach of contract.
D'Alessio alleged that the defendants concocted a phony interpretation of
various '34 Act and NYSE regulations and knowingly disseminated that incorrect
interpretation to the detriment of D'Alessio and other floor brokers. D'Alessio
alleged that the NYSE, in an effort to keep its activities secret and curry
favor with law enforcement authorities, assisted the United States Attorney's
Office and the SEC in their investigation and prosecution of D'Alessio by
knowingly providing them with false information about D'Alessio (and further
failing to disclose to these authorities that it had approved and encouraged the
practice of "flipping," the specific type of unlawful trading for
which D'Alessio had been charged). D'Alessio attributed the NYSE's inaction to
the substantial fees earned by the NYSE and its clearing members on the high
volume of "flipped" trades and to its desire to increase its daily
volume. D'Alessio contended that, as a result of the NYSE's alleged misconduct,
he incurred legal difficulties and has been unable to work as a NYSE floor
In considering a motion to dismiss, the United States District Court for
the Southern District of New York framed the pending question as asking whether
NYSE employees "who, pursuant to statutory delegation, perform regulatory
functions that would otherwise be performed by the Securities and Exchange
Commission are entitled to the same immunities from suit to which comparable
Commission employees would be entitled." In deciding that issue, the Court
[u]nder the federal securities laws, the Exchange "performs a variety of
regulatory functions that would, in other circumstances, be performed by a
government agency," namely, the Commission. Barbara, 99 F.3d at 59. Mutatis
mutandis, the Exchange and its employees, in performing these functions, should
be accorded the same absolute immunity that would be afforded the Commission and
its employees in parallel circumstances. See Austin Mun. Securities, Inc. v.
National Ass'n of Sec. Dealers. 757 F. 2d 676, 688 (5th Cir. 1985) (extending
absolute immunity to another national securities exchange and its employees).
This is a matter not simply of logic but of intense practicality, since, in the
absence of such immunity, the Exchange's exercise of its quasi-governmental
functions would be unduly hampered by disruptive and recriminatory lawsuits. See
Barbara, 99 F.3d at 59; Austin 757 F.2d at 688.
On appeal, the United States
Court of Appeals for the Second Circuit affirmed the lower court's ruling and
After reviewing the complaint, we agree with the district court's
determination that the NYSE's alleged misconduct falls within the scope of
quasi-governmental powers delegated to the NYSE pursuant to the Exchange Act
and, therefore, conclude that absolute immunity precludes D'Alessio from
recovering money damages in connection with his claims.
In reaching its
decision, the Circuit Court specifically cited approvingly the District Court's
above-referenced mutatis mutandis explanation, and further explained that the
NYSE, as an SRO, stands in the shoes of the SEC in interpreting the securities
laws . . . and in monitoring compliance with those laws. It follows that the
NYSE should be entitled to the same immunity enjoyed by the SEC when it is
performing functions delegated to it under the SEC's broad oversight authority.
Question: If the D'Alessio quasi-governmental/absolute immunity inference is
compelled as a matter of logic and practicality, then does not the following
syllogism have equally sound footing? To wit:
Under the federal securities laws,
SROs perform a variety of regulatory functions that would, in other
circumstances, be performed by the SEC. Mutatis mutandis, the SROs and their
employees, in performing these functions, should be accorded the same absolute
immunity that would be afforded the SEC and its employees in parallel
circumstances. This is a matter not simply of logic but of intense practicality,
since, in the absence of such immunity, the SRO's exercise of its
quasi-governmental functions would be unduly hampered by disruptive and
Accordingly, witnesses compelled to give testimony
before SROs are appearing under circumstances similar to that presented before
the SEC (or other governmental agency) and should be entitled to the same
constitutional protections afforded such parallel parties. Similarly, this too
is a matter not simply of logic but of intense practicality, since in the
absence of such constitutional protections, the witness' testimony before a
quasi-governmental entity would be unduly coerced and lacking appropriate due
So much for a foolish consistency being the hobgoblin of
small minds. D'Alessio declares that an SRO is a quasi-governmental entity when
engaged in its regulatory role --- it stands in the SEC's shoes! And this
federal court's interpretation is used against a registered person seeking to
sue an SRO and its officers. The reward of such quasi-governmental status is
absolute immunity bestowed upon the SROs --- a veritable legal shield if ever
there was one. However, when an SRO is pursuing a registered person and that
target seeks to assert a Constitutional right against self-incrimination, the
SRO amazingly transforms itself into a non-governmental, private party. Now the
SRO is armed with a prodigious sword. And they say there's no magic left in the
More to follow in the next installment!
United States of America v. Alan C.
Solomon, 509 F.2d 863, Fed. Sec. L. Rep. ¶94, 948 (2nd Cir.
Jan. 14, 1975, Friendly, J.)
An interesting bit of dicta in Solomon
was the Court’s discussion as to whether Solomon was coerced into not
asserting his Fifth Amendment privilege before the NYSE by a threat of
mandatory “permanent loss of
employment in the only business which he knew." See, Garrity v. New
Jersey,385 U.S. 493, 87 S.Ct. 616, 17 L.Ed.2d 562 (1967).
Solomon noted that in Garrity, the applicable
state statute used the words “shall be subject to a proceeding to
have you removed from the department” (Ed: a requirement that police
officers under oath answer questions pertaining to their office), whereas
the NYSE’s Constitution stated that one “may be suspended or
expelled” for failure to testify. Additionally,
Solomon notes that “there would be a complete breakdown in the
regulation of many areas of business if employers did not carry most of the
load of keeping their employees in line and have the sanction of discharge
for refusal to answer what is essential to that end.”
Martin Graman, v. National Association Of
Securities Dealers, Inc., et al., 1998 WL 294022,
(No. Civ. A. 97-1556-JR., April 27, 1998, D.D.C.)
Anthony J. Marchiano v. National Association of
Securities Dealers, Inc., 134 F. Supp.2d 90 (D.D.C., Feb. 16, 2001)
D.L. Cromwell Investments, Inc., et al. v. NASD
Regulation, Inc., 132 F. Supp.2d 248 (S.D.N.Y., Feb. 26, 2001)
Notwithstanding its ruling, the Court urged the
NASDR to “give careful attention to its arrangements concerning assistance
to criminal investigations and to the relationships, both physical and
administrative, between CPAG [NASD’s Criminal Assistance Prosecution Unit
(sic)] and DOE [NASD’s Division of Enforcement].
The present arrangements left doubt sufficient to require a trial as
to the independence of DOE’s 8210 requests . . .”
Department of Enforcement v. Frank A. Persico,
http://www.nasdr.com/pdf-text/oho_dec01_16.txt (Disciplinary Proceeding
No. C10000139, April 30, 2001)
See,Exchange Hearing Panel Decision 01-20
(John Henry Libaire, Jr), http://www.nyse.com, (February 8, 2001) (“[L]ibaire
informed Enforcement, by his attorney, that he would assert a claim of
privilege under the Fifth Amendment to the U.S. Constitution and would not
be providing the explanation requested by Enforcement. Enforcement advised
Libaire’s attorney in this conversation, in substance, that the Fifth
Amendment only applies to governmental proceedings and thus is inapplicable
to Exchange proceedings.”); Exchange Hearing Panel Decision 00-176
Michelle McDonough a/k/a Michelle Sarian,http://www.nyse.com,
(October 10, 2000) ([E]xchange advised McDonough’s attorney that the
Exchange is not a government agency and does not recognize the invocation of
the Fifth Amendment . . .”)
Sparta Surgical Corporation v. National
Association of Securities Dealers 159 F. 3d 1209, Fed. Sec. L. Rep. ¶
90, 318 (9th Cir. November 6, 1998) (No. 97-15394)
Partnership Exchange Securities Company v.
National Association of Securities Dealers, Inc. et al. 97-16497,
CV-96-02792-DLJ (February 25, 1999)
John R. D’Alessio, D’Alessio Securities,
Inc. v. New York Stock Exchange, Inc., Richard A. Grasso,Edward
A. Kwalwasser, and Robert J. McSweeney, 125 F.Supp.2d 656, Fed. Sec. L.
Rep. ¶ 91, 227 (S.D.N.Y. Sept. 29, 2000) affirmed2001 WL 815541,
--- F.3d ---, (2nd Cir., July 19, 2001).
SEC Chairman Harvey L. Pitt appeared as counsel on behalf of Appellees.)
A version of this article
appeared in the eSecuritiesnewsletter in August 2001 (volume 3, No.
12): Reappraising Self Regulation: Examing Judicial Findings of
Quasi-Governmental Status for SROs. Reprints of that article may be
ordered from Law Journal Newsletters, 105 Madison Avenue, New York, NY