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News March 28, 2011 Issue

FINRA Openly Pitches To Run IA SRO

Everyone has two sides to their mouth, and it is always interesting to watch when someone speaks out of both of them at the same time.

FINRA CEO Rick Ketchum told the crowd at the SIFMA Compliance and Legal Division’s Annual Seminar last week that FINRA is ready to regulate advisers and should be authorized to do the job.

The pitch came in the same breath he used to apologize to the crowd for FINRA’s shortcomings in examining broker-dealers.

Here’s how his logic played out:

It’s a matter of investor protection, said Ketchum. FINRA needs authority over advisers to properly oversee dual registrants. For joint broker-dealer/IA firms, FINRA is limited in its ability to "look fully at what is an equally integrated business." That, coupled with "the fact that currently, investment adviser firms are being examined, on average, only once every decade, if at all," he said, create what he believes is a significant risk to investors.

Ketchum observed that the SEC’s study on the examination of advisers recommended several options to Congress, one of which is to authorize one or more SROs to assist the SEC. He derided the SEC’s "campaign" to obtain additional funding in order to comprehensively regulate advisers itself. "I don’t think it takes a political pundit to recognize that the reality of that happening is unlikely," he said.

Here’s why Ketchum thinks FINRA should be the new adviser SRO:

The opposition’s argument is simple, said Ketchum. FINRA is not qualified because it only regulates broker-dealers and therefore doesn’t understand the differences between the two models. As a result, advisers would be forced to live under a broker-dealer regime. "Frankly," he said, "that’s simply wrong."

Even though the services they provide are "virtually indistinguishable to the average consumer," there are important differences between broker-dealers and advisers, he observed. Any entity that would be empowered to oversee advisers would need to recognize that and regulate accordingly – "and FINRA most certainly would," he said.

If FINRA became the SRO for some or all advisers, said Ketchum, forcing the full suite of specific broker-dealer requirements on advisers would not be appropriate or in the public interest. The regulatory concerns regarding investment advisers primarily relate to the lack of examination resources, which places advisory clients at unacceptable risk. FINRA’s position has been and remains that SROs – especially for stand-alone advisers – should be viewed as a positive development for investors.

Fiduciary duty is a "hollow protection."

"No matter how rigorous the regulatory requirements, an adviser’s obligations may provide only hollow protection to investors absent rigorous examination and enforcement," said Ketchum. FINRA, he noted, is well positioned to provide that service.

Advisers don’t need more rules, but just in case, FINRA is experienced in the SEC’s rulemaking approval process.

FINRA would tailor oversight to the particular characteristics of the investment adviser business, said Ketchum. "We don’t see the necessity for extensive SRO rulemaking and believe that the extent of that authority should be fully a matter for the SEC to determine." Of course, as it does with SROs now, the Commission would approve all rules. Ketchum noted that when rulemaking for advisers under an SRO regime would occur, FINRA and its predecessor entities have more than 70 years experience with the process and "would have no problem operating the same way in the IA space."

The other red herring related to FINRA serving as an adviser SRO, said Ketchum, is the argument that FINRA’s governance structure would only reflect broker-dealer interests and not have adviser representation. Ketchum emphasized that this would not be true.

If FINRA becomes the SRO for investment advisers, its governance structure would appropriately reflect investment advisers. "This would be carried out most effectively by setting up a separate affiliate that would have a board comprised of majority public representatives, but members of the investment adviser industry would be allocated the remaining seats," he said.

Debate over how to increase adviser oversight is worthwhile, but the time to act is now, he urged. Ketchum, a self-described "proud ‘alumni’" of the SEC, said he would never suggest the Commission couldn’t do the job if it had the resources. "But the idle hope of that funding should not justify more delay." He noted that Commissioner Elise Walter also believes the time to act is now because "investors deserve no less."

Apologies for a lacking exam program.

At the same time he was pitching for FINRA to run any adviser SRO, Ketchum spent a significant portion of his remarks describing how FINRA plans to ‘raise its game’ to be a better regulator of broker-dealers.

Over the last two years broker-dealers have made it clear that they continue to be frustrated with regulators, he said. Concerns include that examiners have lacked understanding of the broker-dealer’s business and lacked appreciation of where some of the most serious risks reside.

"We get it," said Ketchum. "We recognize that one-size-fits-all regulation is a thing of the past." FINRA has already taken steps to focus exam teams on those areas that pose a real risk to investors. FINRA is expanding its coordinator program, which maintains dialogues with firms to help FINRA better understand how firms are evolving. FINRA added 20 coordinators and accompanying surveillance managers to its district staff in the sales practice program since last year.

This expansion, which essentially separates the exam function from the surveillance function, has served to decrease the ratio of firms per coordinator and improve FINRA’s exam planning process, he said.

FINRA has hired more expertise, and is revising the exam approach to be more risk-focused and risk-defined. At the end of last year, FINRA launched its Office of Risk to help guide the exam program’s focus and keep it current on changes to the industry and how they impact FINRA’s regulatory programs.

"Similar to what we’ve heard about exams, we have also been aware for some time that the member application process does not always work as well as it could," said Ketchum. So, FINRA is making "significant" changes there, too. FINRA is evaluating its entire program in an effort to improve the application process while maintaining core investor protection principles.

FINRA’s member oversight program will undergo a transformational process over the next two to three years, said Ketchum.

FINRA plans to pursue that vision by:

Strengthening FINRA’s ability to identify high-risk firms, branch offices, brokers, activities and products through broader data collection and more comprehensive analysis.

FINRA plans to collect more data to understand a firm’s business better and more data about branches to better identify riskier branch offices and target regulatory resources. FINRA will process more standardized data as well, to enhance automated risk and compliance efforts."For regulated firms, more standardized data means you won’t need to constantly react to ad hoc information requests," said Ketchum. Examiners will reference standard reports and ask firms to submit the data on one or more of those reports.

Product analysis will also be conducted and new analytical techniques are being tested. For example, FINRA is testing ‘link analysis,’ a network analysis technique that explores associations between objects with existing data to identify otherwise hard to detect relationships between brokers, activities and entities.

Leveraging the data FINRA collects to make exams more effective and enable more work to be done off-site.

"Two to three years from now, far more will be done to better prepare our field examination staff prior to their arrival at your firms." FINRA will acquire product reference data and bind this information with the transactional and customer data to develop profiles to run through risk and compliance scenarios. This will enable FINRA examiners to "better detect the needle in the haystack that deserves their attention," said Ketchum.

Spending more time while on-site getting a better understanding the firm’s risks and how well the firm manages or mitigates its risks.

Key business personnel will be interviewed and the firm’s controls will be carefully assessed.

Providing guidance to the industry through information learned from ‘thematic’ reviews so that better practices are identified and described.

These reviews will involve a targeted number of firms and will be built around a specific theme, like new product development, where the examiners develop a deeper understanding of the business, risks and controls in a certain area.

Learnings from these reviews will influence changes to the exam program, and may also result in additional guidance to the industry and investors. The results will also be used as a reference point with which to assess other firms’ practices in a given area.

Building a flexible exam framework to help FINRA better identify and "size up" material risks to investors, the markets and FINRA.

The recently expanded coordinator program is a key component of this transformed examination framework, said Ketchum. Going forward, the combination of the qualitative information collected through coordinators and on-the-ground exam staff and the quantitative information gathered through data collection and analysis through FINRA’s new Risk Office will better enable FINRA to identify risk and decide where, how and with what intensity to apply its resources.

The net effect of these objectives, once realized, is to better enable the development of examinations that are tailored to those areas that pose the greatest risk to investors and the markets.

"In the end, our job one is to protect investors, but that’s your job one, as well. We can do this better if we do it collectively, if we do it together, and with better communication," he said.

Single standard of care and a brochure for broker-dealers.

As final thoughts, Ketchum offered kudos to the SEC for concluding that a single standard of care is warranted for advisers and broker-dealers. He also highlighted FINRA’s October 2010 concept release on the idea of a broker-dealer brochure.

The SEC has issued a "thoughtful and forward-looking" study with respect to the standard of care for broker-dealers and investment advisers that took an important step toward a single standard of care, said Ketchum.

There are several areas where FINRA can work together with the SEC to bring the standard forward in a fast and effective way even before final action is taken by the SEC.

Let’s start with disclosure, he said. "Disclosure alone is insufficient to address fiduciary issues but it is a critical cornerstone to make it work." The industry needs to get away from overloaded account statements that investors simply ignore. That is a fundamentally flawed approach to disclosure, he said.

This issue should be thoughtfully reviewed well before any Commission or FINRA rulemaking. Ask your firm and ask yourselves the following, challenged Ketchum:

"How do we interact in an effective way with investors? How do we create a level of knowledge and understanding from the standpoint of investors? And how do we deliver that message both with respect to existing technology tools and with respect to a full understanding of your financial advisers as to how they go through the message?"

The concept proposal on a Form ADV-like disclosure document for broker-dealers was a direct response to those inquiries, he said. The proposed rule would require firms, at or prior to commencing a business relationship with a retail customer, to provide a written statement that describes the types of accounts and services it provides. Firms would also be required to disclose the conflicts associated with such services.

It’s a challenge that is not easy and should incorporate both a regulator’s and an industry participant’s view of the right way to do it, he observed.

"We need to figure out the right combination of how to capture investors’ attention up front; how to provide detail from a web-based standpoint; how to use minimalist but effective point of sale disclosure to remind customers of the questions they should be asking again and again," said Ketchum.

The result would be to move to an environment dramatically different than what we have had for the last 20 years, he said. It would be to shift the presumption to that you have conflicts, you have incentives, all firms do. Knowing that, how do you provide disclosure and effective communication with customers so they’re able to make those decisions in a rational way.

"It’s an exciting opportunity and I think it’s something that shouldn’t just be addressed by regulators. It is something that I invite everyone in this room to participate in as part of the dialogue," he said.