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Is FINRA’s Future in Doubt?

Posted by Larry Doyle on February 23, 2010 2:04 PM |

Are the days of Wall Street’s self-regulatory organization known as FINRA numbered?

In the opinion of the very credible Project on Government Oversight, they should be. Why? Significant failures, massive conflicts of interest, and more. POGO’s comprehensive and scathing letter to four separate House and Senate committees touches upon every failing within FINRA, with the exception of the integrity of the proxy statement used in the formation of the organization itself. Strong allegations in a current lawsuit against FINRA make the case that Mary Schapiro lied verbally during roadshows and in the proxy statement. (For details on this lawsuit read here.)

Despite not addressing the issues embedded in that lawsuit, POGO touches all the other bases and covers all the other issues surrounding this organization.

America deserves to be introduced to the organization that, in my opinion, squarely has a foot in both the Wall Street and Washington camps. I make no excuses in categorically stating that FINRA defined the Wall Street-Washington incestuous relationship.

I have no interest in vindication of my writing so much about FINRA over the last thirteen months. I have every interest in exposing the issues embedded in this organization. America needs to truly learn about the issues surrounding FINRA and how and why this organization failed to uphold its charge to protect investors.

I congratulate POGO for bringing these issues to the Hill. I humbly submit and STRONGLY recommend you read, review, and share this letter with friends and colleagues.

The pursuit of truth, transparency, and integrity within the Wall Street financial regulatory system goes to a whole new level with this letter:

February 23, 2010

House Committee on Financial Services
House Committee on Oversight and Government Reform
Senate Committee on Banking, Housing, & Urban Affairs
Senate Committee on Finance

Dear Chairman and Ranking Member:

The Project On Government Oversight (POGO) is writing to raise concerns that Congress’s efforts to reform the financial regulatory system have not adequately addressed the failures of the private self-regulatory organizations (SROs) that are tasked with protecting the investing public and maintaining the integrity of our financial markets. Specifically, we urge you to take a much closer look at the Financial Industry Regulatory Authority (FINRA)—an SRO that regulates thousands of securities brokerage firms—and to consider whether FINRA can ever be an effective regulator given its cozy relationship with the securities industry.

POGO is an independent nonprofit that investigates corruption and other misconduct in order to achieve a more effective, accountable, open, and ethical federal government. As such, POGO has a keen interest in ensuring that the nation’s financial watchdogs are operating with sufficient independence from the industry they are tasked with regulating.

We encourage you to examine FINRA’s poor track record and its inherent conflicts of interest, and to question whether SROs in general should be allowed to play such a prominent role in our nation’s financial regulatory regime.

FINRA Attempts to Expand Its Authority Despite Abysmal Track Record

FINRA was created in July 2007 when the Securities and Exchange Commission (SEC) approved a rule change combining the National Association of Securities Dealers (NASD) with the regulation, enforcement, and arbitration functions of the New York Stock Exchange (NYSE). In its proposed rule change, NASD argued that the “consolidation will…serve to enhance oversight of U.S. securities firms and help ensure investor protection.”1 In response to concerns raised by public commenters, NASD affirmed that the “investor ultimately would be better protected by a single, more efficient regulator.”2

Today, FINRA’s website and brochures continue to highlight the organization’s commitment to “putting investors first.”3 FINRA has also spent a lot of money defending its record through advertisements in The Washington Post, commercials on CNN, and “public interest” spots on National Public Radio.4 One possible reason for all the publicity is that FINRA seems to be angling for more power. This apparent power grab continued at a recent congressional hearing when FINRA Chairman and CEO Richard Ketchum testified that FINRA should be given the authority to oversee investment advisers in addition to securities brokerage firms.5 In an attempt to justify this expanded authority, Ketchum argued that FINRA has a “strong track record in our examination and enforcement oversight.”6

However, POGO believes that FINRA’s track record tells a very different story. In fact, financial sector self-regulators, despite the power vested in them by the federal government, have failed to prevent virtually all of the major securities scandals since the 1980s.

FINRA’s recent failures are detailed in Amerivet Securities, Incorporated v. FINRA, a case that is currently pending before the D.C. Superior Court in which Amerivet, a California-based broker-dealer, is seeking to access some of FINRA’s books and records. As Amerivet’s complaint points out, FINRA failed to oversee and regulate a number of large member firms that were at the heart of the financial crisis, including Bear Stearns, Lehman Brothers, Merrill Lynch, Madoff Investment Securities, and Stanford Financial Group. The complaint goes on to state that “FINRA knew or should have known about the fraud being perpetrated by several of its most influential members, but there is nothing in the public record to indicate that FINRA conducted any oversight of these now-failed malefactors or their senior executives.” 7

Even an internal review conducted by FINRA itself found that the organization missed several key opportunities to investigate the securities fraud by R. Allen Stanford.8 And while FINRA officials have denied any wrongdoing in the failure to detect Bernard Madoff’s Ponzi scheme, securities law scholar John Coffee testified before Congress that “Madoff’s brokerage business was by definition within…FINRA’s jurisdiction.”9

An investigation by The Wall Street Journal further confirmed that FINRA and its predecessor NASD, under the leadership of current SEC Chairman Mary Schapiro, had a decidedly light touch when it came to regulation and enforcement, with significant declines in disciplinary fines assessed, individuals barred, and firms expelled during her time at the organization.10

Outrageous Executive Compensation Packages

Despite its countless failures, FINRA’s board has approved outrageous compensation packages for the organization’s senior executives. Tax documents show that in 2008—a year in which FINRA also lost $568 million in its investment portfolio—the organization’s 20 senior executives received nearly $30 million in salaries and bonuses. Mary Schapiro alone received over $3 million, in addition to a lump-sum departing payment worth $7.2 million.11 FINRA’s decision to reward its senior leadership with seven-figure salaries and bonuses—at a time when many of its larger member firms were getting away with securities violations that brought our financial markets to the brink of collapse—ought to raise serious concerns about granting the organization any additional regulatory authority.

Failure to Warn the Public about Auction Rate Securities

In its 2008 annual report, FINRA described the recent collapse of the auction rate securities (ARS) market:

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.

Of course, the report omits any mention of the fact that FINRA had liquidated its own $647 million ARS investment in 2007 without giving any warning to other investors, who now have tens of billions of dollars stuck in the ARS market. In fact, NASD knew well before then that ARS shouldn’t be treated like cash or cash equivalents, explaining in its 2003, 2004, and 2005 annual reports that it was classifying its own auction rate securities as available-for-sale investments.12 Yet FINRA neglected to warn the investing public about the risks posed by ARS investments until it was far too late. Congress should at least investigate the circumstances surrounding NASD’s liquidation of its ARS investment before deciding to grant FINRA any additional authority to “protect” investors.

Incestuous Relationship Between FINRA and the Securities Industry

FINRA’s numerous failures should hardly come as a surprise given the incestuous relationship between SROs and the financial services industry. It has been said that the close connection with industry allows self-regulators to respond to industry malfeasance more rapidly than a public entity. However, POGO believes that the cozy relationship between SROs and industry is a major reason why entities such as FINRA have failed to operate as effective regulators.

For instance, Amerivet’s complaint against FINRA points to several connections between NASD and the Madoff family:

On information and belief, (1) Bernard Madoff joined NASD’s Board of Governors in January 1984 and served as Vice Chairman while his Ponzi scheme was well underway, (2) he had previously held a number of NASD committee assignments since the 1970s and was instrumental in the development of NASDAQ, (3) he also headed NASDAQ, (4) his brother, Peter Madoff, served as Vice Chairman of the NASD, (5) Mary Schapiro, former FINRA CEO, appointed Mark Madoff, one of Bernard Madoff’s sons, to the National Adjudicatory Council, a regulatory body that reviews disciplinary decisions made by FINRA, and (6) Bernard Madoff’s niece, Shana Madoff, a “Compliance Officer” of Madoff until the firm’s collapse, was a member of a compliance advisory committee of FINRA.13

There were also close connections between FINRA and Stanford Financial Group: Lena Stinson, director of global compliance at Stanford, served on FINRA’s membership committee, while Frederick Fram, chief operating officer of Stanford Group Holdings, served on FINRA’s continuing education committee.14

And it appears the financial crisis did nothing to weaken the close ties between FINRA and the securities industry. Even a cursory examination of FINRA’s current leadership paints a clear picture of a regulator that is still captured by the industry it is tasked with regulating. Richard Ketchum is a former General Counsel for the Corporate and Investment Bank at Citigroup, Inc.15 Robert Errico, FINRA’s Executive Vice President for Member Regulation, is a former Senior Vice President for Capitals Market Oversight at Charles Schwab & Co., and a former General Counsel for Schwab Capital Markets L.P.16 Susan Merrill, FINRA’s Executive Vice President and Chief of Enforcement, is a former partner at Davis Polk & Wardwell, which represents some of the largest financial institutions in the world.17 And on FINRA’s Board of Governors, many of the members that are supposed to represent the public’s interest have close ties to the securities industry.18 Given that SROs such as FINRA are supposed to be the front line overseers for many financial products, POGO believes that the cozy relationships built into this system create a serious conflict of interest.

Investors and Taxpayers Forced to Foot the Bill

In an apparent attempt to sell the idea that FINRA should have more supervisory authority, Richard Ketchum told Congress that “the increased manpower and enhanced investor protection would come at no cost to the taxpayer” because SROs are funded exclusively by the entities they regulate.19 Unfortunately, this funding system amounts to a user tax on investors in the form of transaction costs. And, of course, taxpayers must foot the bill for the SEC’s oversight of FINRA and other self-regulators, which entails approving SRO rules, monitoring their activities, hearing internal appeals, and overseeing board activities.

Time to Challenge the Government’s Reliance on SROs

In various pieces of legislation aimed at reforming the financial regulatory system, Congress has called for an independent review of SROs such as FINRA. For instance, Section 7304 of the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173), which recently passed in the House, would require an independent analysis to determine “whether adjusting the SEC’s reliance on self-regulatory organizations is necessary to promote more efficient and effective governance for the securities market.”20

We would go one step further. In light of FINRA’s abysmal track record, and the flawed premise of self-regulation in general, POGO calls on Congress to consider vastly curtailing the power of SROs. Effective, independent, and efficient government regulation is the only proper way to safely oversee our markets. Our economy is too important to be left in the hands of the very financial industry that brought us to the brink of collapse.

We look forward to working with your Committee on this important issue. If you have any questions or need additional information, please contact me or POGO Investigator Michael Smallberg at (202) 347-1122.


Danielle Brian
Executive Director

1 Securities and Exchange Commission. “Self Regulatory Organizations; National Association of Securities Dealers, Inc.; Notice of Filing of Proposed Rule Change to Amend the By-Laws of NASD to Implement Governance and Related Changes to Accommodate the Consolidation of the Member Firm Regulatory Functions of NASD and NYSE Regulation, Inc.” March 20, 2007. (Downloaded February 18, 2010)

2 Securities and Exchange Commission. “Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Approving Proposed Rule Change to Amend the By-Laws of NASD to Implement Governance
and Related Changes to Accommodate the Consolidation of the Member Firm Regulatory Functions of NASD and NYSE Regulation, Inc.” July 26, 2007. (Downloaded February 18, 2010)

3 Financial Industry Regulatory Authority. Putting Investors First: Your Guide to FINRA and Its Investor Services (Downloaded February 18, 2010)

4 Sarah Lynch. “New Finra Ad Campaign Talks Tough On Fraud.” Dow Jones Newswires. June 15, 2009. (Downloaded February 18, 2010)

5 Testimony of Richard G. Ketchum before the House Financial Services Committee. October 6, 2009. (Downloaded November 13, 2009)

6 Testimony of Richard G. Ketchum before the Senate Committee on Banking, Housing, and Urban Affairs. March 26, 2009. November 13, 2009)

Amerivet Securities, Incorporated v. FINRA, No. 09-cv-1715 (D.D.C.). August 10, 2009. February 18, 2010)

Report of the 2009 Special Review Committee on FINRA’s Examination Program in Light of the Stanford and Madoff Schemes. September 2009. (Downloaded November 13, 2009)

9 Testimony of John C. Coffee, Jr., before the Senate Committee on Banking, Housing, and Urban Affairs. January 27, 2009. (Downloaded November 13, 2009)

10 Randall Smith, Tom McGinty, and Kara Scannell. “Obama’s Pick to Head SEC Has Record Of Being a Regulator With a Light Touch.” The Wall Street Journal. January 15, 2009. (Downloaded February 18, 2010)

11 Cuneo, Gilbert & LaDuca, LLP. “NASD/FINRA Member Litigation – FINRA Records Inspection Litigation.”  December 3, 2009. February 18, 2010); and Tomoeh Murakami Tse. “Starting Public-Sector Jobs With Parting Gifts in Hand.” The Washington Post. February 10, 2009. February 18, 2010)

12 Darrell Preston. “Finra Oversees Auction-Rate Arbitrations After Exit.” Bloomberg. April 29, 2009. February 18, 2010); and Larry Doyle. “NASD Knew Auction Rate Securities Weren’t Cash.” Sense on Cents. May 11, 2009. (Downloaded February 18, 2010)

13 Amerivet Securities, Incorporated v. FINRA, No. 09-cv-1715 (D.D.C.). August 10, 2009. February 18, 2010)

14 Anna Driver. “Stanford workers had ties to regulator FINRA.” Reuters. February 24, 2009. (Downloaded February 18, 2010)

15 Financial Industry Regulatory Authority. Richard G. Ketchum. (Downloaded November 13, 2009)

16 Financial Industry Regulatory Authority. Robert C. Errico. (Downloaded November 13, 2009)

17 Financial Industry Regulatory Authority. Susan L. Merrill. (Downloaded November 13, 2009)

18 For example, William Heyman is a former Vice Chairman and CIO of St. Paul Travelers,; Richard Pechter is a former Chairman of the Financial Services Group at Donaldson, Lufkin & Jenrette,; and John Schmidlin is a former CIO of JP Morgan Chase, (All downloaded November 13, 2009)

19 Testimony of Richard G. Ketchum before the House Financial Services Committee. October 6, 2009. (Downloaded November 13, 2009)

20 “Wall Street Reform and Consumer Protection Act of 2009” (H.R. 4173). (Downloaded February 18, 2010)

I could not have said it better myself.


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