FINRA vs. Fiero Brothers. This 14-year fight between the broker-dealer regulator and a former tiny penny-stock brokerage firm ended yesterday with no winners - so to speak.

The firm was shuttered and its owner, John Fiero, was barred from the industry.  Yet, both refused to pay the fine and ultimately FINRA wound up in federal court trying to collect the money.

On Wednesday, a federal appeals court in Manhattan ruled that FINRA does not have the right to take its members to court to enforce its disciplinary actions.  The surprise decision curbs FINRA's powers, at a time when it has been under pressure to impose greater accountability on its licensed brokers and brokerage firms.

Nexus of the Dispute. In December 2000, after legal disputes that lasted several years, FINRA accused Mr. Fiero and his firm of violating federal fraud statutes - specifically, engaging in a manipulative activity known as naked short-selling. Regulators blamed Mr. Fiero and other “naked shorts” for bringing down a small clearinghouse that served 41 other small brokerage firms.  Clearinghouse failures are rare and potentially dangerous, since they can greatly magnify the consequences of a single firm’s failure.  FINRA, then operating as NASD, expelled the firm and issued a $1 million fine, which never was paid.  Which led NASD (now FINRA) to go to court in order to collect the money. Since banned brokers cannot return to the industry unless they pay any unpaid fines, it has been extremely rare for FINRA to sue to recover unpaid penalties.  Until now, both FINRA and its members assumed that it had the power to do so, if necessary.   Knowing now that this isn't the case, those who receive stiff fines, should they choose to do so, can leave the industry no longer in fear FINRA's long arm can ever reach them. The Court's Opinion. A 3-judge panel of the United States Court of Appeals for the Second Circuit ruled that FINRA had no right to do that.  By its opinion, written by Judge Ralph Winter Jr., the panel unexpectedly overturned a lower court and ruled that neither the nation’s foundational securities laws, adopted in 1934, nor a “housekeeping” rule adopted by NASD in 1990, gave it the right to pursue its monetary sanctions in court.

“The principal issue is whether the Financial Industry Regulatory Authority Inc. has the authority to bring court actions to collect disciplinary fines.  We hold that it does not and reverse.”

Reaction to the Decision. T. Grant Callery, FINRA's general counsel, said the regulator would “continue to review the ruling and weigh our options,” and insisted the decision wouldn't affect its “ability to enforce FINRA rules and securities laws, to discipline firms or protect investors.”   Some securities law experts expect the ruling to have both practical and psychological effects.

• John Coffee, Jr., Securities Law Professor at Columbia. He sees the decision neutering FINRA because its “teeth have been surgically removed.”

• Martin H. Kaplan, a lawyer for Mr. Fiero and his firm, said the regulatory landscape has changed in a profound way.”

• The Appeals Court noted that FINRA still has its most potent weapon  - the power to suspend or expel misbehaving brokers from the financial industry, described as “draconian” power.

• Susan Merrill, a securities lawyer who recently left FINRA as the head of enforcement, said the decision cast an adverse light on the process FINRA used to adopt the 1990 rule and, potentially, other “housekeeping” rules.

• Relevant to that point, the court said the 1990 rule should have been given a more formal review, with an opportunity for public comment, because it did not deal with mere housekeeping matters.  Rather, the rule “affected the rights of barred and suspended members to stay out of the industry and not pay the fines imposed on them in prior disciplinary proceedings.”

Impact on the Securities and Exchange Commission. The court’s criticism will also sting a bit at the SEC, which currently is Chaired by Mary Schapiro.  Ms. Schapiro was Chairman and CEO of FINRA during much of the time it pursued the Fiero case in court. [Dealbook, 10/6/11]