FINRA has the not-inconsiderable powers of censuring brokers, imposing fines, ordering restitution to investors, suspending brokers and even barring them from the industry.
Is it now time to bar FINRA from the industry?
If that provocative question resonates with financial advisors, among whom the organization is not universally popular, that may only reinforce the thesis of a new research paper claiming that the industry self-regulatory organization (SRO) is not a true SRO, which would presumably enjoy its members’ wide support.
Indeed, Hester Peirce, a senior research fellow at George Mason University’s Mercatus Center argues in “The Financial Industry Regulatory Authority: Not Self-Regulation After All” that the organization exhibits “a troubling independence from government, industry and the public.”
“People think of FINRA as a self-regulator, and that brokers run it and that it’s accountable to brokers. But it’s not accountable to brokers and not accountable to the public” is how Peirce put in a phone interview with ThinkAdvisor.
“And it’s not adequately accountable to the [Securities and Exchange Commission],” she continued. “The SEC has some control, but FINRA sets its own budget and hires its own people outside of the purview of the SEC.”
Peirce adds that this “inadequately accountable operation” is actually growing in importance through an expansion of its role in securities markets and thus must now be held to account — either by folding it into the SEC or by transforming the institution into a true SRO.
The researcher at the free-market oriented Mercatus Center favors the latter.
“One approach would be to stop deluding ourselves and make this a governmental regulator,” Peirce said, “I don’t think that’s the best approach, given that the SEC also has its own problems.
“But the SRO model could be very effective at protecting the public,” she explained, “because you’re harnessing the most upstanding members of the industry to, acting in their self-interest, keep out the bad actors.”
(Peirce was once an SEC staff attorney and counsel to Commissioner Paul Atkins. She now sits on the SEC’s Investor Advisory Committee.)
In practice, Peirce says FINRA acts independently of, and in a sense is hostile to, the industry it ostensibly represents.
Her paper cites the organization’s governance as an example: “The board structure, which is intentionally weighted away from the industry, is not consistent with self-regulation. An organization run by a board that is dominated by people who are not in the industry is not an SRO; it is a regulator with industry representation,” it says.
What’s more, Peirce, who describes herself as a “big believer in procedure,” highlights weak mechanisms of institutional accountability.
For example, unlike governmental regulatory authorities that are designed to be accountable to Congress, the president and the public, FINRA does not have politically accountable directors or commissions — as does, say, the SEC — nor does Congress have oversight of its budget-setting.
What’s more, FINRA is not subject to the Freedom of Information Act, which would provide the public with access to documents about its internal workings, nor is it bound by the Administrative Procedure Act, which requires public agencies to seek public comment about costs and benefits before adopting rules.
Peirce cites as a current example FINRA’s current Comprehensive Automated Risk Data System (CARDS) proposal, which would establish a centralized database collecting individual investor account information. The rule would be costly for FINRA members who would have to oversee the monthly data collection.
While she says the proposal has gotten “negative comments from industry folks” such as the Securities and Financial Markets Association, Peirce points out that the move to adopt CARDS comes precisely at a time when the industry is struggling to implement FINRA’s Consolidated Audit Trail (CAT) requirement.
“It’s just an odd structure [FINRA’s governance model], because you don’t have the industry running it,” Peirce comments. “Members of the industry feel it’s an outside regulator that doesn’t particularly understand their business. They’re saying [of CARDS and CAT] that ‘you’re not taking into account that we have limited resources [to handle both at same time].’”
Another unusual aspect of FINRA’s neither-fish-nor-fowl organizational model relates to its disciplinary discretion to impose fines on members.
“I have grave concerns that they can impose fines and it goes right into their coffers [unlike government agencies that turn such monies over to the U.S. Treasury] — that creates very strange incentives,” Peirce said. “It’s generally not healthy when the regulator imposing a fine can take that fine and use it for its own purposes … That’s a wrongheaded approach. It takes the blinders off justice and creates an incentive to get money.”
Relatedly, Peirce’s paper notes the high level of compensation for FINRA’s leadership. Its CEO earns $2.25 million a year, considerably more than the SEC chairwoman’s annual salary of $165,300.
Finally, the area of potential abuse that is perhaps most acutely felt at the street level is the organization’s enforcement actions against advisors.
Not unlike the currently publicized witch hunts on college campuses where accused students are not afforded the rights defendants have in U.S. courts, advisors accused of suitability violations sometimes settle even when they disagree with the charges against them.
She cites a case she read about in which such an advisor “just settled and got out of the industry… because the process was very expensive” and the lack of due process protections added to the advisor’s difficulties.
While Peirce says it is possible that FINRA had a great case against the advisor (“I didn’t look at the details”), she adds based on anecdotal information that “surely there are cases where the person who [refused to fight FINRA] had a meritorious case.”
The Mercatus research fellow concludes that the American public is most hurt by an unreformed FINRA — “that’s because we’re being sold a regulatory scheme that looks a lot more just than it actually is,” she explained. “A close second to that are people interested in being in that industry. Because it does change their decision about whether to enter the industry and whether that’s a system they want to subject themselves to.”
Peirce says that it’s not just the rogues but honest financial advisors whose lives are adversely affected by FINRA’s procedures. “Even a good broker is going to have customer complaints because when people lose money, they complain,” the expert says.
While there are two approaches — one governmental and one industry-based — to increasing public disclosure and procedural obligations to increase accountability, Peirce advocates making FINRA into a true SRO.
That, she argues, is the longstanding tradition in U.S. securities markets going back to the New York Stock Exchange and over-the-counter markets. The combination of industry expertise and funding, and a self-interest in rooting out crooks, beats the track record of government regulators and trumps the inadequacies she finds in FINRA, her research paper argues.
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