finra

Rick Ketchum
Chairman & CEO, FINRA

The Exchequer Club
Washington, DC
June 17, 2009

As prepared for delivery.

 

Thank you, Paul, for that introduction, and thank you to the Exchequer Club for the invitation.

 

I'd like to acknowledge Commissioner Elisse Walter, who was, until last year, Senior Executive Vice President for Regulatory Policy and Programs at FINRA. Elisse has dedicated her career to investor protection—both from a regulatory and investor education standpoint. She's a vocal advocate for investors and has long been on the forefront of identifying issues that may harm investors and working with the industry and other regulators to solve problems. Thank you for coming today, Elisse.

 

I'd like to begin by providing some historical perspective—albeit history that should all be fresh in our minds, because it was only two years ago. On June 15, 2007, a Friday, the Dow closed at 13,639—and over the three preceding days it had risen nearly 350 points. The optimism of the period was captured by a Financial Times columnist, who wrote two days earlier that the global economy was characterized by "fast growth, huge current account 'imbalances,' low real interest rates and risk spreads, subdued inflation and easy access to finance." The columnist posed a rhetorical question, "Is this party about to end?" To which he replied, "Probably not."

 

Little did this columnist know that June 2007 was something of an inflection point, as it marked the first real sign of distress in the markets. Two years ago today, the New York Times published an article that carried the ominous headline, "When Does a Housing Slump Become a Bust?" On the same day, investors in two hedge funds at Bear Stearns learned that the funds had suffered major losses. Redemptions were frozen, and the firm was forced to inject $1.5 billion into the two funds. We all know how that story ended, and the events that followed sparked an upheaval throughout the financial markets and the U.S. banking system, a plunge in investor confidence and a severe slowdown of global economic growth.

 

Last December's arrest of Bernard Madoff, and the revelation that he had been operating a multi-billion dollar Ponzi scheme for decades, was another body blow to a financial system that was already reeling. The immediate victims were, of course, his investors. But coming in the midst of a prolonged period of market turmoil, the disclosure of what he had perpetrated also contributed to a broader erosion of investor confidence. For he quickly emerged as a symbol of all that was wrong in the markets—personifying for many the unethical behavior that seemed to have infected the system, and contributed to the plunge in market indices. And given his status as a respected veteran of the securities industry, many investors were left to wonder if he was truly an outlier, or emblematic of how the industry operates.

 

That episode, and countless others, has left everyone operating in and around the markets to try to sort out what has unfolded over the past two years, while also remaining vigilant regarding the possibility of more threats to market stability. And the economic and market indicators today are decidedly mixed. In the first quarter, for example, the economies of the 30 OECD countries contracted 2.1 percent, which was the largest decline since the OECD started keeping records in 1960. Conversely, in the three months spanning from March through May, the S&P 500 index rose 25 percent—the largest three-month gain since 1938.

 

While some of my best friends are economists and market forecasters, I'm neither, so rather than try to predict what's going to happen next, I'll stick with the boilerplate language you've probably all heard before: past performance is no guarantee of future results.

 

Having worked on the regulatory side of the securities industry for most of my professional life, here's what I do know: we are at a rare moment when there's an opportunity to pursue comprehensive reforms that will make the financial sector's regulatory architecture more robust, will help prevent a repeat of the kind of volatility we've seen over the past two years and—most important—will strengthen investor protections. That work is well underway.

 

So today I will share some of my thoughts on regulatory reform, and provide some guidance on the work underway at FINRA and the principle of independent regulation under which we operate—and why I believe it is more relevant than ever in the new regulatory world we are moving into now. I also want to touch on the issue of how investment advisers and broker-dealers are regulated, as this is an important element of protecting investors and fostering investor confidence.

 

FINRA

 

After many years of working in the regulatory system, I am proud to have joined the Financial Industry Regulatory Authority back in March.

 

Starting with some of the basics of FINRA, we have a staff of 2,800, and we regulate the practices of nearly 4,900 brokerage firms, about 174,000 branch offices and more than 650,000 registered securities representatives. FINRA also acts as the primary examiner and rule enforcer for those firms and their employees, under the oversight of the SEC. We are an advocate for investors, dedicated to keeping the markets fair, ensuring investor choice and proactively addressing emerging regulatory issues, hopefully before they harm investors or the markets.

 

FINRA, like all regulators, must take accountability for the last two years and passionately search for ways to become more effective and to enhance investor protection. At FINRA, that process is well underway.

 

In early March, we created an Office of the Whistleblower, to encourage individuals with first-hand knowledge of, or material information about, potentially illegal or unethical activity to come forward and share it with regulators. You would be amazed at how the simple act of raising your hand, and creating a centralized investigative unit, has enabled us to uncover instances of alleged wrongdoing. In the first three months of operation, the Whistleblower Office has received nearly 100 tips. Many of these tips have contained highly credible regulatory intelligence of frauds ranging from Ponzi and affinity schemes to test cheating and boiler rooms. We have made a number of referrals to the SEC and we have a number of cases currently under investigation at FINRA.

 

One case I can share with you has already resulted in a complaint against a non-registered entity named Diversified Lending Group, which offered high-yield promissory notes to investors. We referred this alleged Ponzi scheme to the SEC and on March 4, they issued an emergency asset freeze against Diversified Lending and its principal, Bruce Friedman. The complaint alleges that Friedman diverted substantial investor money to ventures unrelated to real estate, and also misappropriated at least $17 million to support his lavish lifestyle, including purchases of a luxury home, cars, vacations and jewelry for himself and an alleged girlfriend, who is named as a relief defendant.

 

We have also conducted a comprehensive review of examination and regulatory programs to help us better identify red flags that may indicate fraud. Since learning of the Madoff fraud, we have launched two broad regulatory reviews:

 

  • custody issues in firms that are registered as both broker-dealer and investment advisers; and
  • the role of broker-dealers as feeders or finders for money managers such as Madoff.

 

On the latter issue, we've launched a sweep examination to review the type of activity evident in the Madoff scheme. That's just the beginning of where we want to go—we're looking across the organization to coordinate and enhance our regulatory programs.

 

Independent Regulation

 

Before I touch on the details of possible changes to the U.S. financial system's regulatory infrastructure, I'd like to speak to one important dimension of this infrastructure—independent regulation.

 

With most large broker-dealers now operating as part of bank-holding companies, and with the prospect of a systemic regulator being created, it is natural to ask what impact that should have on securities regulation and, in particular, on non-governmental regulators such as FINRA.

 

Independent regulation in the securities industry has a long and effective history. Congress designed the statutory scheme of this type of regulation for the securities markets in the 1930s, envisioning that most of the day-to-day responsibilities for market and broker-dealer oversight would be performed by a self-regulatory organization under the SEC's direct oversight. The SEC was charged with supervising SROs and compelling them to act where they failed to provide adequate investor protection. Congress's preference for this type of regulation was deliberate; it recognized that it was impractical for the government to provide the necessary resources to effectively regulate the securities industry.

 

This model of securities regulation has proven effective for the past 75 years. Both Congress and the SEC have periodically examined the role of independent regulation in the securities industry, and while each has taken steps in certain instances to remedy shortcomings, the concept of independent regulation has been repeatedly reaffirmed and strengthened.

 

FINRA's model has many important benefits to investors and the markets. We work with the financial industry to ensure investor protections and market integrity, while remaining firmly independent of it. We can and do extend past enforcing just legal standards to adopting and enforcing ethical standards, such as the just and equitable principles of trade. Government regulation is well suited for policing civil or criminal offenses, but less so for ethical lapses, which, while not necessarily illegal, may be unfair or hinder the functioning of a free and open market. Independent regulation is uniquely capable of protecting investors from those sorts of transgressions.

 

Private funding is another critical advantage to the FINRA model. Millions of dollars can be spent on examination, enforcement, surveillance and technology at no cost to the taxpayer. Independent regulators also are better positioned to move quickly to address regulatory issues because, among other things, they are not subject to many of the spending restrictions of the federal government, and are better able to develop large-scale systems for important regulatory matters like market surveillance, broker registration and trade reporting.

 

Moreover, the evolution of FINRA and its legacy organizations stands as a clear response to the most common concern expressed about SROs—that they are subject to industry conflicts. FINRA is a not-for-profit company that operates independently of any securities marketplace with a board that has a majority of governors that have no relationship with any broker-dealer. In short, FINRA offers a well-funded, sophisticated regulatory infrastructure, staffed by a select corps of professionals who are deeply versed in the complexities of securities markets yet motivated, first and foremost, by a determination to protect investors and promote market integrity.

 

Regulatory Reform

 

Turning to regulatory reform, as many of you surely know, earlier today the Obama administration released its proposals for reforming the U.S. financial regulatory infrastructure.

 

The Obama administration has identified a number of key priorities, which include controlling systemic risks, tightening regulation of non-bank activities, enhancing protections for consumers, establishing a resolution mechanism for the resolution of systemically important financial holding companies, and improving regulation throughout the world.

 

These are all important, but we should not lose sight of the key lessons from the past, which are that financial regulatory systems tend to stand still, while the financial industry is in a state of perpetual motion—constantly offering new products to new customers. One commentator has summed this up with the observation that "banking is the only industry where there is too much innovation, not too little."

 

This poses a fundamental challenge for regulators and policymakers. While the immediate task is to reform the regulatory architecture to address the many vulnerabilities in the financial system and help restore investor confidence, part of the long-term objective must be to create an architecture in which regulations can evolve to adapt to the inevitability of changed circumstances in the financial sector. If we simply look backward, we will be, in some sense, "fighting the last war." The real test will be whether the regulatory system can evolve along with the financial system and help to prevent the excesses that are destined to develop.

 

As an example, it appears to be wise policy to identify a systemic regulator and focus all functional regulators, through a council, more continuously on issues that raise systemic risk. Similarly, it is, in my view, appropriate to impose more conservative capital and leverage requirements on the largest financial firms that carry the implied guarantee of "too big to fail." Yet, just as the supposedly risk-reducing characteristics of asset securitization morphed into a monster of unaccountability, the reality of today is the fragmentation of activity and risk. The inevitable result of mutual fund regulation has been the growth of hedge funds. The inevitable result of broker-dealer regulation has been unregistered high-frequency traders. The inevitable result of futures and options regulation has been the creation of the OTC swaps market. And the inevitable result of securities offering regulation has been the growth of private offerings and private capital.

 

This is meant in no way to question the validity of any of these regulatory structures that are fundamental to efficient markets and investor protection, but only to note the reality that in today's global environment, products and intermediaries will change to fill specific needs and avoid, wherever possible, the costs of regulation. We could, of course, control this tendency by shifting to a more command and control economy, but few would recommend it and, moreover, it would be self-defeating, unless embraced across all major global markets. The administration's plan probably does the best it can to address this gap by filling regulatory voids in the OTC derivatives and hedge funds, and given the Fed cross-market systemic authority. But let me predict today that the next serious crisis will not come from Citibank or Bank of America, but from entities that today we would not recognize.

 

One way of thinking about this is to remember what Wayne Gretzky once said when asked what made him one of the world's greatest hockey players. He said he skated to where the puck was going, not where it has been. And while it may be foolhardy to think regulators can ever operate with the agility and grace of The Great One, we can be better prepared to identify looming challenges and to help prevent them from engulfing the financial system. Easy to say, but asking financial systems to be prescient is illusory. The best we can do is to demand a new standard in which government regulators and organizations like FINRA establish cultures that demand a sophisticated understanding of the industry, and are always outward-looking and aggressive in responding to those inflection moments when the impact of market changes become clear. Moreover, we must demand that both regulators and elected officials around the globe be more cautious about grabbing at short-term competitive benefits at the cost of seeding new products of long-term risk. What's needed, if you will, is a regulatory structure that fills the gaps, reacts more quickly to industry changes and focuses more carefully on ensuring that needed innovation does not come at too great a cost of investor risk and systemic exposures. A tall task, but one to which we must all respond.

 

The administration has correctly identified that a critical part of creating this more balanced—or as Secretary Geithner referred to it, "more boring" regulatory environment—is addressing the profoundly inconsistent regulatory protections that exist across different financial products and different intermediaries. It cannot continue to be the case that consumer protections vary dramatically depending on whether the customer is sold a security, future, insurance or banking product. Yet our current system of financial regulation has created an environment in which investors are left without those consistent and effective protections.

 

It is perhaps for that reason that the administration recommended today the creation of a Consumer Financial Protection Agency. Such an agency may indeed be appropriate in areas like mortgage and consumer loan financing where there has been relatively little previous focus on customer protections. The administration appropriately concluded, however, that it would not be wise to give such an agency jurisdictional reach into securities—where detailed SEC and FINRA rules and a substantial examination and enforcement infrastructure are in place—because such a system would lead to inconsistent and duplicative regulations.

 

Yet we must face the problem of disparate consumer protections across product areas. While steps like the merger of the SEC and CFTC might make sense and address this problem in part, I agree with the administration's judgment that life is too short to move down that path again.

 

Instead, I believe a better approach would be to identify a set of common investor-protection principles and require each regulatory organization to both certify that it has developed rules that implement each of these principles and also to require them to actively work with the other relevant regulatory organizations to harmonize their rules to enhance consistent treatment.

 

Without suggesting an exclusive list, I would recommend these principles should include the following:

 

  • Every person who provides financial advice and sells a financial product is tested, qualified and licensed;
  • Advertising for financial products and services is not misleading;
  • Every product marketed to them is appropriate for recommendation to that investor;
  • A full and comprehensive disclosure for the services and products being marketed that address, in plain English, the risks, including the worst-case risks, of the product; and
  • Every person who is in the business of regularly providing financial advice is subject to a federally crafted fiduciary standard.

 

IA Issue

 

Whatever is accomplished in creating more consistent consumer protections across financial products, the most glaring example of a regulatory gap that needs fixing is the disparity between oversight regimes for broker-dealers and investment advisers. For while they are distinct entities, the everyday reality is—as the Rand Institute said in a study last year—that "trends in the financial service market since the early 1990s have blurred the boundaries between them." This underscores the pressing need for a consistent standard that distinguishes between investment advisers and broker-dealers.

 

For example, the absence of a comprehensive examination program for investment advisers impacts the level of protection for every member of the public that entrusts funds to one of those advisers. Indeed, the Madoff episode revealed the risks in having separate regulatory bodies to oversee investment advisers and broker-dealers, especially when these businesses may exist in the same legal entity.

 

And I am happy to see that the Obama administration agrees that there needs to be a focus on this issue. The white paper on regulatory reform released today by the White House calls for harmonizing the regulation of investment advisers and broker-dealers.

 

The SEC and state securities regulators play vital roles in overseeing both broker-dealers and investment advisers, and they should continue to do so. But it's clear that dedicating more resources to a regular and vigorous examination program and day-to-day oversight of the investment advisers could improve investor protection for their customers, just as it has for customers of broker-dealers.

 

As the SEC has noted, the population of registered investment adviser firms has increased by more than 30 percent since 2005. Investment advisers now number 11,300—more than twice the number of broker-dealers.

 

Consider the contrast: FINRA oversees 4,900 firms and conducts over 2,500 regular exams each year. The SEC oversees more than 11,000 investment advisers, but in 2007 conducted fewer than 1,500 exams of those firms—not because of lack of desire but lack of resources. Indeed, the SEC has said recently that in the fiscal years of 2009 and 2010, it projects that it will examine just 9 percent of investment advisers each year. FINRA and the SEC, by contrast, are projected to examine 55 percent of broker-dealers each year.

 

In recent months, dozens of Ponzi schemes and other frauds committed by money managers and investment advisers have underscored the need for additional oversight of investment advisers. There is also a need for investment advisers to be subject to a rigorous examination program, along the lines of what FINRA requires of broker dealers.

 

The following examples illustrate my point.

 

  • In March, the SEC charged a Chicago-area investment adviser and two of its principals for misappropriating more than 4 million dollars in client assets, making misrepresentations to their clients, failing to comply with custodial obligations and failing to keep required books and records. The firm's owner was convicted in 1992 of a felony in connection with a tax evasion and money-laundering scheme.
  • And, just last week, a New York investment adviser was charged with stealing 6 million dollars from clients. He appears to have aimed his activities at the most vulnerable, including the elderly, dying and mentally impaired. The charges brought by the U.S. attorney's office for the Southern District of New York and the New York office of the FBI include fraud, lying to investors and converting money for his own use. He also faces charges from the SEC over alleged theft of client funds.

 

These examples underscore the importance of investors researching the backgrounds of the individuals who approach them with investment proposals. We have seen individuals who had been barred by FINRA and other securities regulators surfacing in a number of recent frauds, resulting in millions of dollars in losses. Investors need to be able to check if their financial professional has been the subject of a disciplinary action by regulators, which is why FINRA has proposed a major expansion of our BrokerCheck service—to make records of final regulatory actions against brokers permanently available to the public, regardless of whether they continue to be employed in the securities industry.

 

Another important issue, which has been the subject of extensive discussion within the financial sector, is the difference between the fiduciary standard for investment advisers and the rule requirements, including suitability, for broker-dealers. We agree with the Obama administration that a fiduciary standard should be established for broker-dealers when they are offering investment advice. The best analysis, in my view, of this complex issue was expressed recently in a speech by Commissioner Walter.

 

In the simplest terms, when financial advice is being offered by a broker, a fiduciary duty should apply—two different standards are simply untenable in this world for persons engaging in very similar activities.

 

But a proper fiduciary standard alone is insufficient. We also believe that the kind of additional protections provided to investors through the FINRA model are essential. The question of whether FINRA should be vested with the authority to regulate investment advisers is ultimately for Congress and the SEC to answer. But from my perspective, FINRA is uniquely positioned to build an oversight program that ensures investment advisers are properly examined and their customers are adequately protected.

 

Conclusion

 

I started this speech by reflecting on events from two years ago. Let me close with a short story from 102 years ago.

 

After many years of strong economic growth, the Dow Jones Industrial Average started to weaken in the first quarter of 1907, and ultimately declined nearly 25 percent. Uncertainty brewed for months, and it exploded in October of that year, when allegations of malfeasance were directed at a number of leading trust companies. Depositors rushed to withdraw their savings, and the even more fundamental problem was a collective lack of confidence, among investors, both in the banking system and in the ability of anyone to repair the damage. The panic only subsided after J.P. Morgan—the individual, not the institution—persuaded leading financiers to put aside their differences and inject 25 million dollars into the banking system.

 

Out of this episode came the recognition that some kind of entity was needed to strengthen the U.S. financial infrastructure, which culminated in the creation of the Federal Reserve a few years later, and has served as a pillar of the U.S. financial system ever since.

 

That episode provides a useful reminder that crises can also be opportunities. And I'm hopeful that in the months that follow, policymakers, regulators, industry officials and investors can foster a consensus around regulatory reforms that will enhance investor protections, help to restore investor confidence and prevent the kinds of market mayhem we saw over the past two years—and 102 years ago.

 

But it's just as important for everyone throughout the financial industry to remember that regulation and oversight alone will not prevent every instance of fraud or deception. What's most important of all is for market participants to act with integrity, and to comply with not just the letter of the laws, but also their spirit. A market imbued with a strong commitment to ethics will breed trust and confidence and enable markets to serve as an engine of growth in the United States and throughout the world.

 

Thank you.