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 proceedings. 

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. 

After nearly 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 unfair? 

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 Exchange Act." 

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"

Non-governmental actors 

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, Inc., 763 F.Supp. 584, 589 (S.D.Fla.1991); United States v. Bloom, 450 F.Supp. 323, 330 (E.D.Pa.1978).
[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 prosecutors. 

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 criminal investigation. 

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 that 

[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).
[Ed: emphasis supplied] 

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? 

Now, 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 broker. 

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 explained that 

[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 held: 

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 recriminatory lawsuits. 

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 process protections. 

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 world.

 More to follow in the next installment!


  1. 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.)

  2. 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.”

  3. 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.)

  4. Anthony J. Marchiano v. National Association of Securities Dealers, Inc., 134 F. Supp.2d 90 (D.D.C., Feb. 16, 2001)

  5. D.L. Cromwell Investments, Inc., et al. v. NASD Regulation, Inc., 132 F. Supp.2d 248 (S.D.N.Y., Feb. 26, 2001)

  6. 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 . . .”

  7. Department of Enforcement v. Frank A. Persico, http://www.nasdr.com/pdf-text/oho_dec01_16.txt (Disciplinary Proceeding No. C10000139, April 30, 2001)

  8. 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 . . .”)

  9. 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)

  10. Partnership Exchange Securities Company v. National Association of Securities Dealers, Inc. et al. 97-16497, CV-96-02792-DLJ (February 25, 1999)

  11. 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).  (Note: current 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  10016.



Telephone: 917-520-2836
Fax at 720-559-2800
E-mail to bsinger@rrbdlaw.com