Is FINRA Fatal? The Impact Of Extending SROs To Investment Advisers


By: Kirill Kan

The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for securities firms doing business in the United States. As a Self-Regulatory Organization (SRO), FINRA is tasked with market regulation through contract with major U.S. stock markets, including the New York Stock Exchange, NYSE Arca, NYSE Amex, the NASDAQ Stock Market and the International Securities Exchange.

Under the supervision of the SEC, FINRA (1) writes, (2) interprets, and (3) enforces the rules that govern the brokerage industry. A fact that has come under attack more frequently in recent years is that FINRA accomplishes these goals through management by its members, comprised entirely of brokerage firms. To illustrate the type of incentive problem this creates, SRO opponents need only point to Bernard Madoff. Madoff served on the Board of Directors and later as vice-chairman at FINRA’s predecessor, the National Association of Securities Dealers (NASD).

For investors, FINRA effects justice through the operation of the largest dispute resolution forum for broker/dealers doing business with the public. For brokerage firms, using FINRA (a non-government private entity) for dispute resolution in lieu of formal litigation is attractive because of the anonymity established as a result of the inapplicability of the Freedom of Information Act to private entities. Accordingly, upwards of the 4,000 new disputes filed each year are handled behind closed doors and out of the public view.

Oversight of investment advisers, unlike brokerage firms, has always been handled directly by the SEC and state regulators. This system of oversight has been significantly more effective in providing transparency to the resolution of disputes between investment advisers and clients. The Dodd-Frank Act, enacted last year, directed the SEC to look into the practices of financial advisers in response to high-profile frauds such as the aforementioned Bernard Madoff Ponzi scheme. According to the study the agency needed to address its inability to inspect a sufficient number of investment advisers on a regular basis. In response to this concern, Representative Spencer Bachus, Chairman of the Committee on Financial Services, proposed the Investment Adviser Oversight Act of 2011 (“Act”). If passed, the Act would create a “national investment adviser association” or an SRO for investment advisers. FINRA has already voiced its excited willingness to assume responsibility for this newly created SRO which would regulate investment advisers. The goal of Mr. Bachus’ Act, to respond to the low level of investment advisor regulation, is admittedly a valuable objective in light of an SEC report finding that only 9% of registered advisers are examined annually due to the SEC’s lacking resources. Whether this is best accomplished through an SRO is far from clear. Even if an SRO is the best method by which to increase regulatory review of investment advisors, is FINRA the proper organization to be charged with this duty?

On October 27, the SEC ordered FINRA to hire an independent consultant and undertake other remedial measures to improve its policies, procedures, and training for producing documents during SEC inspections. According to this order, the demands were made in response to the production of altered documents by FINRA’s Kansas City District Office, the third such case during an eight-year period in which an employee of FINRA or its predecessor NASD submitted altered (or misleading) documents to the SEC. What SRO opponents do not emphasize, however, is that FINRA had self-reported the matter, and then responded to it by (1) appointing new leadership in the Kansas office, (2) changing document submission procedures, and (3) cooperating with the subsequent SEC investigation.

Should FINRA be the organization that acts as an SRO for financial advisers if the Act is passed? FINRA’s increased resources and expertise mitigate in favor of allowing FINRA to merely expand its scope to financial advisers. Conversely, FINRA already oversees nearly 4,495 brokerage firms, about 163,450 branch offices and approximately 635,515 registered securities representatives. Including financial advisers in the mix may just place all the parties with the wrong incentives at the helm of financial regulation.





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Fordham Journal of Corporate & Financial Law