Regulating Regulators

The Courts act to protect the rights of the regulated

By Mark J. Astarita  

Securities attorneys have often suffered the frustration of dealing with regulators who attempt to enforce rules which are unclear, and sometimes, unwritten. While the SEC, FINRA and the state securities authorities have broad powers to enforce their statutes and rules, they must apply those rules in a consistent and even handed manner. When they do not, the Courts will regulate the SEC

Government agencies and self-regulatory agencies have an obligation to act in a manner that is not arbitrary or capricious. That is, they have an obligation to clearly define their rules, and interpretations of their rules, so that the persons can understand an application of the rules whose conduct is subject to the jurisdiction of the agency. This only makes sense, as one cannot be expected to conform his conduct to a rule or standard until the rule and standards are defined by the regulatory agency.

While it is not a widespread problem, all too frequently registrants and others find themselves being held to a standard of conduct, or an application of a rule, that did not exist before they committed their acts, which, after the fact, become violations. The ramifications are extremely serious, since such rule violations can often result in severe sanctions, including the loss of a license.

Recently, two appellate courts have struck down findings of violations, and permanent bars, by agencies, because the agency went beyond their stated rules and interpretations.. While each case has specific factors which make them unique, the underlying principles – the requirement of clearly defined standards, and an obligation to follow the mandate of their regulatory authority, – applies to all actions by regulatory authorities and their staffs.

In July of 1998, the United States Court of Appeals for the District of Columbia, reversed an SEC injunction against two accountants, based on an SEC finding that they had engaged in “improper professional conduct” in violation of Rule 2(e)(1)(ii). The SEC bar prohibited the accountants from “practicing before the Commission,” for a period of five years, a broad term that encompasses preparation of any document for filing with the Commission.

The SEC had barred the accountants for violating Rule 2(e) in connection with their preparation of financial statements, and the accountants appealed because there was no clear standard of conduct enunciated by the Commission. On the original appeal, the court sent the case back to the Commission, and asked the Commission to explain its interpretation of its rule.

On the second appeal, according to the Court, the SEC was “unable to do so, voicing instead a multiplicity of inconsistent interpretations.” The court labeled the SEC’s decision barring the accountants to be “deliberately obscurantist” and “close to a self-proclaimed license to charge and prove improper professional conduct whenever it pleases, constrained only by its own discretion”.

In effect, the court found that the SEC was creating standards as it went along, doing what it wanted, when it wanted, and how it wanted, without any standards to guide the professionals appearing before it.

For those of us who practice in the regulatory area, the decision was an affirmation of what we sometimes experience when dealing with regulators. Often, industry professionals are accused of conduct that has not been defined as being a violation, or are charged with the broad and undefined “failure to cooperate”, “violation of the just and equitable principals of trade” or as in this case, having engaged in “mproper professional conduct.” Those terms are so broad, so over encompassing, as to give a regulator unlimited power to sanction someone, without any standards. Further, such vague violations make violators of persons who believed they were acting properly, only to find out after the fact that the regulator disagreed, and is now, after the fact, determining that the conduct was a violation.

The frustration that those of us who represent clients in the regulatory area sometimes experience was shared by the Court in the case, when it stated: “[i]n summary, the Commission’s opinion yields no clear and coherent standard for violations …[a]lthough we owe substantial deference to an agency’s interpretation of its own regulations,…we cannot defer to an agency when we are at a loss to know what kind of standard it is applying or how it is applying that standard to this record.”

Because of the Court’s concerns with the Commission’s inability to announce a standard by which to measure conduct under Rule 2(e), the Court took the unusual step of dismissing the proceedings against the accountants in its entirety.

In January 1999, the United States Court of Appeals for the Second Circuit reached a similar result in its review of a NASD proceeding which was handled and appealed by my law firm.

In 1995 and 1996 the NASD’s Market Surveillance Committee was conducting an investigation of certain short-selling activities. My firm represented one of the witnesses in the investigation, who appeared at the Staff’s request for an “on the record interview” – a deposition. Our client appeared, was deposed, and was told that he might have to return for an additional day. He then asked for, and received, a copy of the transcript of his deposition.

Eight months later he was called back again, and again, he appeared. At the start of the deposition, he confirmed that he was going to receive a copy of the transcript, but this time the Staff refused to provide a copy of the transcript. The witness then refused to testify without an explanation for the refusal to provide the transcript, which the Staff then refused to give. The witness offered various alternatives, including an agreement to keep the transcript confidential, to no avail. The witness refused to testify, and on the same day, wrote to the head of the Committee, asking for a clarification as to whether the Staff could withhold his transcript, and advising that if the Committee told him he had to testify, without a transcript, he would do so immediately.

The witness was attempting to determine from the Staff and the Committee itself, what authority they had to force him to testify without receiving a transcript of his testimony, particularly since they had readily provided that transcript to him at is first deposition. Since there is no rule or interpretation of a rule that states that he is not entitled to a transcript, the Staff’s position appeared arbitrary and capricious, and quite simply, unfair. The witnesses request for an explanation was simple and would have required a simple answer. However, the Staff refused to discuss the request, and insisted that he testify, under the terms and conditions that they deemed appropriate.

Providing a copy of a transcript to a witness is a routine practice. Having the transcript allows the witness to better review his testimony to insure its accuracy, and is such an important part of a witness’ rights, that in the court setting, the procedural rules require the party taking a deposition to provide a copy of the transcript to the witness – at no cost to the witness.

Unfortunately, in the regulatory area, the rules, and sometimes simple elements of fairness, are not present, and there was no rule at the NASD regarding transcripts, leaving the Staff to make the determination themselves, on a case by case basis, denying a copy of the transcript to some witnesses, permitting access to others, or even sometimes allowing a copy, and othertimes not, for the same witness.

Rather than respond to the witness’s request for a clarification, the Market Surveillance Committee immediately instituted a disciplinary proceeding against the witness, seeking to bar him from the industry for his conduct. A hearing was held, and the NASD found that the witness had violated Procedural Rule 8210 (requirement to provide information to the Staff) and Conduct Rule 2110 (violation of high standards of commercial honor and just and equitable principles of trade). Incredibly, the witness was censured, fined $20,000 and permanently barred from the NASD unless he testified; in which case the bar would be reduced to a six-month suspension.

The witness appealed the decision to the SEC, who agreed with the NASD, but lowered the bar to a six-month suspension, even if the witness continued to fail to testify.

The witness appealed again to the United States Court of Appeals, which reversed the SEC, and vacated the decisions.

In its opinion, the Second Circuit found that the Market Surveillance Committee did not have the authority under the version of Rule 8210 that was in effect at the time, to require the witness to testify, never mind testify without a transcript, and that a reasonable person would believe that he was appearing at the deposition voluntarily, and could therefore appear subject to whatever conditions he thought appropriate. The Court then reversed the SEC and vacated the entire decision,

The case turns, in large part, on the particular factual setting. Rule 8210 was amended after the witness’ appearance, and in amending the Rule, the NASD admitted that the Market Surveillance Committee did not have the authority to compel members to testify. In fact, one of the reasons for the rule change was to give that authority to the Committee.

Therefore, armed with the admission that they lacked the authority, and with overwhelming evidence that the witness himself was acting reasonably and attempting to resolve the issue with the Staff, the appellate court vacated the entire proceeding.

The case has a specific and limited application in that the operative rule has been changed. However, it remains to be seen what the effect will be on other proceedings, where members were fined, censured or barred under the same version of the rule. However, this case, and the earlier SEC case, demonstrate the importance of insuring that the SEC, and the NASD, abide by their own rules, and within the confines of their authority. Regulators cannot take action that is arbitrary, or caprious, and must be able to identify the source of their authority, and to clearly state their interpretations of their own rules. Regulators cannot fashion rules as they go along, and must, repeat, must, give sufficient notice, by way of rule interpretations and public announcements, to those whom they regulate, of what is in fact violative conduct.

Ad hoc, and after the fact pronouncements by the regulators are patently unfair. Our constitution prohibits such determinations in the criminal setting for good reason, and as demonstrated by these two cases, the courts will strike decisions which violate these concepts.

 Keywords: nasd, nyse sec, rules, regulations, enforcement, vacate, appeal, court

Mark J. Astarita is a veteran securities attorney representing investors and financial professionals nationwide in securities investigations and arbitrations. Have a question? Email him at, call his office at 212-509-6544, or visit The Securities Lawyer

Securities Attorney at Sallah Astarita & Cox | 212-509-6544 | | Website | + posts

Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page -, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.