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FINRA 2008 Annual Report: A Special Type of Hubris

Posted by Larry Doyle on June 29, 2009 3:14 PM |

At first blush, I viewed the text of the Financial Industry Regulatory Authority’s (FINRA’s) 2008 Annual Report as nothing more than standard corporate fare.  With the benefit of a few days to ponder FINRA’s delivery, I am actually amazed, although never surprised, by the gall of this regulatory organization. In fact, I can only describe FINRA as displaying a special type of hubris in addressing the fraud encompassing Auction-Rate Securities.

I personally believe it is very important for a financial self-regulatory organization, such as FINRA, to be totally transparent in every regard. Why? Very simply, transparency promotes confidence and FINRA’s position as a financial regulator should begin and end with that goal.

Against that backdrop, FINRA should not directly manage any of their own funds. To do so is an open invitation for conflicts of interest. FINRA’s own investment portfolio, managed by an Investment Committee, generated a negative 26% return in 2008. In April 2009, the FINRA portfolio shifted to a lower volatility approach but in 2008 it continued to have exposure to hedge funds, fund of funds, and private equity. As much as I believe this is a very big deal, it pales in comparison to the major issue I, and others, have with FINRA: their involvement with Auction-Rate Securities. Let’s dive into this part of the report and comment as appropriate.

FINRA sets the table:

Throughout the financial crisis, FINRA has worked closely with other regulators, particularly the Securities and Exchange Commission and the Federal Reserve, to examine firm activities for compliance with FINRA rules and federal securities laws, investigate wrongdoing and, when rules were broken, enforcing those rules.

As well they should. However, Finra obviously did not work too closely with the SEC to detect the fraud ongoing with Bernie Madoff. In fact, Finra’s only reference to the Madoff situation is one sentence highlighting the fact that the current financial regulatory structure does not overlap the efforts overseeing broker-dealers with those of investment advisors.

FINRA continues to make their case in stating:

The instability in the markets, and at a number of financial institutions, heightened investor fears. FINRA helped to allay those fears, and foster confidence, by working to ensure the protection of customer assets at troubled institutions.

How can they make this statement with a straight face knowing that thousands of investors and tens of billions of dollars remain frozen in Auction-Rate Securities? A number of Wall Street institutions continue to collect fees from these securities. Hubris? You think?

FINRA continues:

Vigorous enforcement of rules and regulations is a cornerstone of FINRA’s work to protect investors. In 2008, FINRA focused its efforts in several areas of investor harm—including excessive commissions, unsuitable mutual fund share class recommendations and sales, penny stock sales and auction rate securities recommendations and sales.

The hubris grows.

Let’s move forward. FINRA boldly and specifically addresses the Auction-Rate Securities market.  I would have thought FINRA may have ducked this topic given the fact that they had sold $647 million ARS in 2007. The fact that they have willingly ‘opened this can of worms’ leaves them subject to fair and open questions. FINRA puts forth:

Auction rate securities (ARS) traditionally had been a valuable source of market liquidity, targeted at investors seeking a cash-like investment that paid a higher yield than money market mutual funds or certificates of deposit. But in February 2008, the ARS market froze, leaving some investors unable to access their holdings. The episode prompted an investigation by FINRA that revealed some firms had sold these securities using advertising, marketing materials or other internal communications with its sales force that were not fair and balanced and therefore did not provide a sound basis for investors to evaluate the benefits and risks of purchasing ARS.

As I read this and reread it, I am struck by the ‘Monday morning quarterback’ approach taken by FINRA. SRO does not stand for ‘self-reporting organization’ but rather self-regulatory organization. FINRA is reporting what happened after the fact instead of having truly protected investors by investigating the sales and marketing of ARS on an ongoing basis. Hubris.

FINRA knew ARS weren’t cash or cash-like even though they were marketed in that fashion. How did FINRA know this? The NASD, FINRA’s parent organization, owned ARS and did not formally account for them as cash given the long maturities of the underlying loans. Sense on Cents highlighted this point in writing, “NASD Knew Auction Rate Securities Weren’t Cash.” Real hubris on FINRA’s part.

The ARS market did not just freeze in February 2008, as FINRA may have readers of this Annual Report believe. The ARS market was failing or freezing for a protracted period before the market totally failed and froze. This is a very important point because there was an untold amount of ARS sold and distributed during 2007 when FINRA could have and should have been protecting investors. Amazing hubris.

Why did FINRA only investigate after the fact? Itself an investor in ARS, FINRA was fully aware of how this product was improperly marketed and distributed. In fact, the sales and distribution of ARS has been designated as a fraud in federal court. FINRA’s assertion of investigating is both comical and pathetic. More hubris.

FINRA continues:

FINRA’s investigation also found evidence that each firm failed to establish and maintain a supervisory system reasonably designed to achieve compliance with the securities laws and FINRA rules with respect to the marketing and sale of ARS.

Investigation? Please, stop the madness! An investigation after a hundred billion dollar market fails is nothing more than a ‘CYA.’ A regulator regulates on an ongoing basis to prevent frauds and protect investors. FINRA failed to uphold its charge on both these fronts.

FINRA asserts:

As of May 2009, FINRA had concluded final settlements with nine firms, imposing a total of $2.6 million in fines and guaranteeing the return of more than $1.2 billion to investors. In all of our ARS investigations and settlements, FINRA’s primary goal continues to be the restoration of investors’ access to the millions of dollars they invested in ARS.

FINRA’s “success” rate is somewhere in the vicinity of 1% (and potentially as low as .007) of all outstanding funds remaining frozen in Auction-Rate Securities a full 16 months after the market failed. Wow! If that is not the definition of hubris, I’m missing something.

FINRA should be honest and write, “the restoration of investors’ access to the tens of billions of dollars they invested in ARS.”

FINRA’s final statement on the ARS topic concludes:

In response to these cases, FINRA launched a special arbitration procedure for investors covered by regulatory settlement agreements. The procedure provided swifter resolution at reduced cost for customers claiming consequential financial harm related to the sudden and widespread inability to liquidate ARS into cash.

Sense on Cents has heard from dozens of ARS investors who continually express frustration at the lack of assistance provided by FINRA.

Not that I expected FINRA to address their own liquidation of $647 million ARS in 2007, but the questions surrounding that sale remain unanswered and critically important to this entire ARS fiasco. Knowing that FINRA will most likely not address these questions, Sense on Cents will direct the following questions to FINRA’s Investment and Audit committees:

1. Through whom did FINRA liquidate their ARS position?

2. What price was FINRA paid for their ARS bonds?

3. What prompted them to sell their entire position at that time?

4. Did FINRA have material, non-public information of the failing ARS market and act upon it?

For our markets to be truly free, fair, and open to all investors, we need total transparency and integrity. What we do not need is a special type of hubris from a financial regulator.


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