Our October 6th Op-Ed, “FINRA Is An Ineffective Regulator,” highlighted FINRA’s push to take over the regulatory oversight of registered investment advisers (RIAs) – a move that is more about FINRA’s own self-preservation and less about investor protection.
FINRA responded to our Op-Ed, claiming that our assertions were unfounded. They concluded that we were just an RIA firm that doesn’t want to be audited.
By way of background, I grew up in the brokerage industry. My grandfather founded the brokerage firm Dayton Haigney & Co. (which later became Haigney Securities, Inc.) in Boston in 1936.
My father took over the firm in 1980 and I worked there for several years until the firm was sold in the early 1990s. Subsequently, I worked for Merrill Lynch as an institutional equity salesman and then in 2009 I founded my firm, EL CAP, Inc., a registered investment adviser based in Vermont.
My family’s broker-dealer was one of the last small full reserve, self-clearing brokerage firms. We were members of FINRA (then known as the NASD) and I was involved in all aspects of our firm’s operations, including financial reporting, regulatory filings and audits. My perspective in this debate crosses both the RIA and broker-dealer worlds and includes, first hand dealings with FINRA, the SEC and the state securities regulators.
Did Anyone From Westrock Get Banned?
In our op-ed, we highlighted the matter of Westrock Advisors, Inc. Westrock, a broker-dealer and a FINRA member between 2002 and 2011, by all accounts appeared to be a good old-fashioned boiler room.
The firm racked up an impressive list of customer complaints and significant regulatory violations in its short history. FINRA repeatedly turned a blind eye and allowed Westrock to continue operating, even in the face of a well-established pattern of investor abuse. Ultimately, the State of Connecticut concluded that Westrock engaged in dishonest or unethical business practices and revoked their broker-dealer registration.
While writing the op-ed, I contacted FINRA several times about the Westrock matter, specifically wanting to know how many individuals were banned from the securities industry as a result of Westrock’s investor harm. FINRA never responded to me, and as far as I can tell not one individual was barred from the industry in connection with the Westrock misconduct.
In FINRA’s response to our piece, they threw out a bunch of statistics about the number of firms and individuals that they’ve suspended or barred over the past 10 years.
Investors may be surprised to know that FINRA suspensions can be as short as 10 days and as a general rule firms and brokers are often barred from the industry because they don’t show up at FINRA disciplinary proceedings or don’t pay FINRA fines. If bad actors want to stay in the industry, they can usually play ball with FINRA and it’s business as usual.
FINRA’s Flawed Logic
FINRA is pushing for the passage of the Investment Advisers Oversight Act of 2011(Act), which would create a new self-regulatory organisation (SRO) to regulate RIAs. Unlike the brokerage industry, RIAs are regulated directly by the SEC (or state securities regulators), a system that has done a good job of protecting investors over the last 70 years. FINRA is positioning itself to run this newly created SRO.
The primary argument in favour of the proposed Act is simply that FINRA audits broker-dealers more frequently than the SEC audits investment advisers. This logic is flawed on multiple levels.
First, broker-dealers require more oversight than RIAs because they are operationally far more complicated. They often have conflicting principal and agency trading functions, complex net-capital and customer reserve requirements, and margin and short sale rules, not to mention the obvious conflicts that arise with investment banking and research activities.
Second, many RIA firms under SEC supervision will soon shift to state level regulation. Currently, RIA firms with assets under management below $25 million are regulated by state agencies, not the SEC. But a provision of the Dodd-Frank Act has raised that threshold from $25 million to $100 million. In 2012, it is estimated that roughly 4,000, or nearly 35% of SEC registered RIA firms, will move from SEC to state oversight, freeing up time and resources for the SEC to focus on larger RIA firms.
Ineffective Regulator… Ineffective Audits
FINRA is promoting their audits like they are a magic potion for investor protection, but a closer look reveals that their audits are a bit more like snake oil.
The most obvious example of FINRA’s audit failures is the Bernard Madoff matter. As we previously pointed out, Mr. Madoff wasn’t just a FINRA member, he was a revered part of FINRA’s leadership for many years, all while running his giant Ponzi scheme.
Mr. Madoff represented to FINRA auditors that his firm was only engaged in market making and trading activities and that its revenues were only generated through buying and selling securities for its own trading account, not by charging commissions to execute trades.
Yet for years, Madoff reported that his firm had significant commission revenues. In 2007, Madoff’s firm reported to FINRA revenues from commissions of $108 million, representing more than 60% of its total revenues. These commissions were directly related to Madoff’s Ponzi scheme, and while the trades may have been fictitious, the commissions were very real.
Madoff’s mysterious commission revenues stood out like a sore thumb on his financial filings, yet FINRA auditors never looked into their source. Mr. Madoff’s Ponzi scheme was hiding in plain sight and with just a few obvious questions any rooky auditor should have blown the cover off of it. FINRA looked the other way.
FINRA Isn’t the Solution
Contrary to what FINRA said about us, we are not opposed to regulatory audits. They are a vital part of every compliance program and good compliance is good business. But audits need to be viewed in their proper perspective. They rarely, if ever, expose wide spread investor fraud. Generally speaking, disciplinary actions are driven by customer complaints and are not the result of routine audits.
In practice, FINRA audits are more about meaningless minutiae that have almost nothing to do with investor protection. In one FINRA audit that lasted for several weeks at my family’s brokerage firm, the auditor absurdly cited us for the fact that our advertising file was out of chronological order, and to top it off, we had only run three advertisements in the year in question.
As we see it, FINRA is part of the problem, not the solution. They are the poster child for the old, dysfunctional way of doing things on Wall Street and their atrocious track record of investor protection can’t be ignored.
Congress needs to just say no to FINRA.
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