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News November 12 & 19, 2012 Issue

Elections Over, FINRA Back on Adviser SRO Warpath

Not that FINRA was ever off the warpath, but it did seem like they took a breather for a few minutes to see which way the wind would blow during the recent election cycle.

With the status quo in Congress essentially preserved – Republicans retained control in the House and Democrats retained control in the Senate – FINRA is once again advancing its arguments for the establishment of a self-regulatory organization (SRO) for advisers. FINRA is also advocating its expertise in the SRO space that it believes puts it at the head of the line to do the job.

On November 15, FINRA executive vice president for regulatory policy Thomas Selman spoke before the Investment Program Association fall conference. His remarks offer a glimpse into FINRA’s psyche, and into the arguments you can expect FINRA to make before Congress in the future.

Selman noted that during the recent consideration of how to protect the customers of investment advisers, some questioned the value of the SRO model.

However, SROs have been around since the "dawn of the federal securities laws" and Congress and the SEC have affirmed its effectiveness many times, said Selman.

"It should come as no surprise that I believe in the SRO model of regulation," said Selman.

The establishment of SROs was the subject of little debate and was codified by Congress with little objection, he said. It was part of that "dawn" of securities laws that broke over the "dark days of the Great Depression."

In 1938, Congress enacted the Maloney Act, which authorized the creation of national securities associations to regulate over-the-counter broker-dealers. The Maloney Act led to the formation of the National Association of Securities Dealers (NASD), FINRA’s predecessor.

Faith in the SRO model.

Selman said that Congressional faith in the SRO model of broker-dealer regulation began then and remains today. He said it emanates from at least two assumptions – that the industry acts in its self-interest and that practical advantages over government regulation abound.

The wind-up.

First, he said, firms will perceive regulation, whether imposed by the government or an SRO, to be in their own self-interest because regulation preserves the integrity of the industry.

Brokers who commit fraud or who abuse their customers will taint the whole industry, and brokerage firms would support regulation to ensure that such actors are expelled from the industry.

Supporters of the SRO model were not naïve men, said Selman. They understood that an industry would support regulation insofar as it is in its self-interest.

Nevertheless, these architects of the statutory SRO model embraced the idea that businessmen and women perceive the preservation of the integrity of their industry to be in their self-interest.

The pitch.

Selman said that a second reason that the SRO model has endured is that it is assumed to provide practical advantages over government regulation. The brokerage industry is large, diverse and complex, he said.

The broker-dealer SRO can establish and enforce conduct rules that address a variety of businesses. It can tap industry expertise to accommodate new industry practices and ensure that its rules will work. "Of course, an SRO does all of this without taxpayer money," he said.

Recent discussions about the SRO model.

Selman observed that despite all these perceived advantages, it became a point of discussion in the recent debate about how to improve the oversight of investment advisers.

Selman offered the following information. He said:

  • The SEC examined only eight percent of SEC-registered investment advisers in 2011;
  • The SEC and FINRA examine about 55 percent of all broker-dealers every year; and
  • Almost 40 percent of all SEC-registered advisers have never been examined.

Selman said that "virtually everybody" agrees that the absence of regular examinations of investment advisers poses a threat to their customers. The only disagreement has been the manner in which this problem should be solved.

The adviser industry supported a user fee to fund SEC examinations. FINRA supported statutory authority for the SEC to designate one or more SROs for the investment adviser industry.

In FINRA’s view, the principal responsibility of these SROs would be to examine investment advisers for compliance with their statutory requirements and to enforce those requirements.

In April, House Financial Services Committee Chairman Spencer Bachus (R-AL), and Representative Carolyn McCarthy (D-NY) introduced H.R. 4624 to provide for an SRO for investment advisers. The legislation generated much discussion about the merits of the SRO model.

Frankly, said Selman, much of this discussion surrounded FINRA’s "willingness" to serve as an SRO for the adviser industry. The industry was worried that FINRA would impose broker-dealer regulation on investment advisers, "despite our assurances to the contrary and provisions in the bill that would have prevented that outcome," he said.

It wasn’t just opposition to FINRA, however. Selman observed that the industry opposed the SRO model itself.

Opposition to the SRO model raises two "internally inconsistent" objections.

According to Selman, adviser advocates claim that an SRO for advisers would be a captive to the investment adviser industry. He said they also complain that an SRO would be insensitive to the investment adviser industry.

He disagreed with each of these ostensible claims.

First, he said that FINRA/NASD has undergone "dramatic" reforms to promote its independence from the brokerage industry it regulates and to avoid industry capture. FINRA continually enhances these reforms, he said.

Over time, the NASD and now FINRA have strengthened its independence from industry influence by adopting measures such as changing its governance structure to include a majority of public members on the Board.

Selman asserted that FINRA pursues its mission of protecting investors and preserving market integrity as a "vigorously independent regulator." He also noted that FINRA’s operations are subject to the SEC’s oversight.

"An SRO designed according to the FINRA model will not—cannot—become ‘captured’ by the industry that it regulates," said Selman.

Selman then turned to the subject of insensitivity to the industry.

While FINRA acts with independence, it still consults with registered firms at every step of rulemaking, he said. Staff typically brings rulemaking ideas to several advisory committees, whose membership includes industry representation. Selman said that he serves as a liaison to three such committees.

FINRA also takes rulemaking to a committee of small members and another committee composed of FINRA's largest members for their consideration. The Board of Governors includes representatives from large, small and medium-sized members, to ensure that the different views of FINRA’s membership are heard.

FINRA typically issues a proposed rule for public comment and receives comments from members. After a rulemaking is filed with the SEC, the SEC also requests public comment.

Industry conferences, such as the one at which he was speaking, are also a valuable opportunity to meet with industry representatives, and to explain what FINRA’s doing and why.

Conferences are an opportunity to hear from the industry about what issues you think are important and suggestions about how to improve FINRA’s regulatory programs.

A premise of the SRO model is that a regulator that opens itself to candid discourse with representatives of the regulated industry will issue rules that are more practically suited to the legitimate business practices of that industry, he said.

Through committees, the Board, through task forces and other ad hoc industry groups, through requests for comment and industry events, FINRA solicits and considers the views of the industry.

FINRA’s independent judgment about how to protect investors through rulemaking is always informed by the views of the industry, said Selman.

Therefore, just as it is incorrect to say that an SRO will become a captive to the industry that it regulates, so is it false to assert that an SRO must be insensitive to that industry's views, he said. 


Selman believes there are two lessons to be drawn from the recent discussions about the SRO model. First, he essentially concludes that advisers have "no interest in regulation."


Because he argues that, in accordance with his prior logic, a self-interested adviser industry would embrace an SRO versus opposing one.

The financial crisis and various scandals have eroded public trust in the adviser industry, he said.

Firms that want to protect their customers from fraud and abuse and evict bad actors from their industry would naturally be in favor of a regulatory scheme (i.e. SRO) that bolsters that public trust.

"I urge you to consider public perception as you supervise compliance within your own firms," he said.

"If you are a broker-dealer, your vigorous supervision for compliance with the federal securities laws and FINRA rules, your aggressive discipline of anybody who engages in a practice that could cause customer harm, your support of good regulation, will help to allay public skepticism about your support for investor protection." 

The second lesson from the recent discussions, said Selman, is that an SRO must be independent of the industry that it regulates, but receptive to that industry's concerns. Every regulator must be willing to examine its mistakes and to make improvements that could help it achieve its mission.

"The mark of good government is not perfection. Rather, it is a government's willingness to reexamine itself and improve. The same holds for any regulator. FINRA is not perfect. But we are enthusiastic about making those changes that will help ensure that we protect investors, while considering the most practical way to do so," said Selman.

He noted that FINRA is presently developing a plan for the economic analysis of significant FINRA rulemakings.

Saying the current rulemaking process is already subject to a "vibrant" public comment process, FINRA will still seek to formalize and make more rigorous its consideration of the potential burdens of a proposed rulemaking.

Selman closed by saying that the most effective regulation of all is ensuring – through industry support of strong regulation and continued engagement in the rulemaking process – that the SRO model thrives to "protect investors and reflect the legitimate business practices of firms."