finra

Thomas M. Selman
Executive Vice President, Regulatory Policy

Investment Program Association Fall Conference

 

Washington, D.C.
November 15, 2012

Good morning and thank you for your kind introduction.

 

During the dark days of the Great Depression, amidst widespread media coverage and intense public interest, the Roosevelt administration and Congress debated the future of financial regulation. Before the stock market crash, there was little appetite for federal regulation of the securities markets. The crash changed that. For the first time, fundamental questions were extensively studied: Should the federal government control the issuance of securities, the allocation of capital and the structure and practices of large industrial corporations? How could speculation on stock markets be reduced? Should the federal government restructure the stock exchanges?

 

From 1933 until 1940, President Roosevelt and Congress resolved those questions when they enacted sweeping legislation. Even today, this legislation serves as the foundation of our federal system of securities regulation. Despite numerous amendments over the years, anyone who participated in the passage of those federal statutes would recognize them today.

 

These statutes resolved many of the great questions that the country faced after the stock market crash. Today I will talk about an issue that does not appear to have been the subject of much debate in the 1930s, the status of self-regulatory organizations. At a time when the questions about how finance should be federally regulated drew the attention of industry, the popular press, and the American public, Congress codified the SRO model with little objection.

 

During the recent consideration of how to protect the customers of investment advisers, some questioned the value of the SRO model. It should come as no surprise that I believe in the SRO model of regulation. This afternoon I will talk about how we can best ensure that it continues to protect investors and ensure the integrity of the financial markets.

 

The SRO Model of Regulation

The authors of the federal securities laws seem to have assumed that self-regulatory organizations would serve as the front-line regulator. One of the earliest drafts of legislation to regulate the stock exchanges was circulated in November 1933. According to its author, "The general idea of the draft here presented is that the bill is to be drawn on the theory that insofar as possible each exchange will discipline its own members and conduct its own affairs." As enacted, the Securities Exchange Act required stock exchanges to register with the SEC and vested the SEC with authority to approve stock exchange rules. But the exchanges retained their pre-existing authority—indeed, their responsibility—to administer those rules and to enforce compliance through disciplinary actions. Indeed, Section 6 of the Exchange Act required all securities exchanges, including the New York Stock Exchange, to function as self-regulatory organizations.

 

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, FINRA's predecessor.

 

Of course, the SRO model has changed since passage of the Maloney Act. In 1983, Congress amended the Securities Exchange Act to require all broker-dealers to belong to at least one SRO. More recently, NASD 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.

 

Faith in the SRO Model

The SRO model has thus existed since the dawn of the federal securities laws, and Congress and the SEC have reaffirmed its effectiveness many times. While the SRO model has undergone significant reforms since 1934, its fundamental construct has endured.

 

This faith in the SRO model of broker-dealer regulation emanates from at least two assumptions. First is the assumption that firms will perceive regulation to be in their own self-interest. 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. They understood that an industry would support regulation insofar as it is in its self-interest; there will be bad actors in the brokerage industry who flout regulation, whether imposed by an SRO or the government. 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. This faith in the industry's willingness to support meaningful regulation has persisted since 1934, although I am not sure that this confidence in the industry is widely held anymore.

 

A second reason that the SRO model has endured is that it's assumed to provide practical advantages over government regulation. The brokerage industry is large, diverse and complex. 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.

 

Recent Discussions about the SRO Model

Despite the longstanding faith in the SRO model, it became a point of discussion in the recent debate about how to improve the oversight of investment advisers. As you are aware, investment advisers are not required to join an SRO. The SEC examined only 8 percent of SEC-registered investment advisers in 2011. By contrast, the SEC and FINRA examine about 55 percent of all broker-dealers every year. Almost 40 percent of all SEC-registered advisers have never been examined. The absence of regular examinations of investment advisers poses a threat to their customers. This is a fact upon which virtually everybody agrees, including the SEC staff, FINRA and even the investment adviser industry. The only disagreement has been the manner in which this problem should be solved. The investment 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. The principal responsibility of these SROs would be to examine investment advisers for compliance with their statutory requirements and to enforce those requirements.

 

Last April, Congressman Spencer Bachus, Chairman of the House Financial Services Committee, and Congresswoman Carolyn McCarthy 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, much of this discussion concerned the fact that FINRA had stated that we would be willing to serve as an SRO for the investment 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.

 

Yet the opponents of H.R. 4624 opposed more than FINRA oversight. They opposed the SRO model itself. They raised two internally inconsistent objections. First, they claimed that an SRO would be a captive to the investment adviser industry. Second, they complained that an SRO would be insensitive to the investment adviser industry.

 

I disagree with each of these assertions. First I want to address the objection that an investment adviser SRO would become a captive to the industry. In the 1990's, NASD agreed to dramatic reforms that promoted our independence from the brokerage industry. These reforms have endured, and even have been enhanced, by FINRA. For example, due to these reforms, a majority our Board of Governors consists of public members, and industry influence was removed from our disciplinary process.

 

FINRA's mission is to protect investors and to preserve market integrity. We pursue our mission as a vigorously independent regulator. All of our operations are subject to the oversight of the Securities and Exchange Commission, an independent regulatory agency. An SRO designed according to the FINRA model will not—cannot—become "captured" by the industry that it regulates.

 

Equally untrue is the assertion that an SRO does not take into account the views of the industry that it regulates. FINRA acts with independence, but we consult with registered firms at every step of rulemaking. Our staff typically brings rulemaking ideas to several advisory committees, whose membership includes industry representation. I happen to serve as liaison to three such committees. Many of you may be familiar with one of these FINRA committees, the Corporate Financing Committee. We also take rulemaking to a committee of small members and another committee composed of FINRA's largest members, for their consideration. Our Board of Governors includes representatives from large, small and medium-sized members, to ensure that the different views of our membership are heard. We typically issue a proposed rule for public comment and we receive comments from our members. After we file rulemaking with the SEC, they will also request public comment, and the brokerage industry does not hesitate to file more comments at that stage.

 

Industry conferences, such as this one, are also a valuable opportunity for us to meet with industry representatives, explain what we're doing and why we're doing it. This conference is an opportunity to hear from you about the issues you think are important and your suggestions about how to improve our 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. Through our committees and our Board, through task forces and other ad hoc industry groups, through our requests for comment and industry events, FINRA solicits and considers the views of the industry. Our independent judgment about how to protect investors through rulemaking is always informed by the views of the industry. 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.

 

Lessons

There are two lessons that we can draw from the recent discussions about the SRO model. First, based on their comments, some opponents of an investment adviser SRO appear to have concluded that the financial services industry has no interest in regulation. While this may be untrue, the financial crisis and various scandals have eroded public trust in the industry. I hope that they have not undermined a fundamental assumption of financial regulation: that firms want to protect their customers from fraud and abuse and evict bad actors from their industry.

 

I urge you to consider public perception as you supervise compliance within your own firms. 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.

 

With these thoughts in mind, I commend the Investment Program Association for the steps it's taken to improve business practices in your industry. I commend the IPA's commitment to establish guidelines for the valuation of unlisted REIT and DPP securities. As you know, the valuation of these securities has been the subject of concern at FINRA. In Regulatory Notice 12-14, we requested comment on a proposal to amend Rule 2340 to address the per share estimated values at which unlisted REIT and DPP securities are reported on customer account statements. Industry commenters generally supported our proposal, and we are considering these comments as we prepare a rule filing with the SEC.

 

As you are undoubtedly aware, the manner in which unlisted REITs are marketed and sold to retail investors was the subject of our recent enforcement action in the David Lerner case. FINRA will not tolerate abusive marketing practices by broker-dealers in the distribution of any security. Your support for new approaches to the regulation of the unlisted REIT and DPP market, such as vigorous standards for valuing, marketing and selling those securities, is the type of support that will improve the public perception of your industry.

 

Of similar concern is the private placement market. On December 3rd, new FINRA Rule 5123 goes into effect. This rule requires a notice filing requirement for some types of private placements. It will enable us to better police the private placement market, which has been the source of many instances of abuse. In our administration of this rule, we will be particularly interested in the extent to which a broker-dealer selling a private placement has undertaken a reasonable inquiry concerning the security and the issuer.

 

As I mentioned, one lesson from the recent discussions about the SRO model is that some may have concluded that the financial services industry has no interest in regulation. I have suggested ways in which the industry could address this perception. The second lesson from the recent discussions 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. FINRA has always been willing to consider reforms that will ensure that we protect investors and preserve market integrity. Some of these reforms I have already mentioned. They are intended to help us achieve a proper balance between independence and sensitivity to legitimate business concerns. As a good example, the composition of our governing board protects our independence by requiring a public majority. It also includes broad broker-dealer representation to ensure that the views of different types of members are heard. These reforms have improved both our independence and our responsiveness to appropriate business concerns.

 

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. We are presently developing a plan for the economic analysis of significant FINRA rulemaking. Our rulemaking already is subject to a vibrant public comment process. Members of the industry and the public often have more than one opportunity to comment on proposed rules. If FINRA receives comments that raise questions regarding the potential costs or burdens of a rule proposal, we respond to these comments in our filing with the SEC. However, we will formalize and make more rigorous our consideration of the potential burdens of our proposed rulemaking. We have posted a position for a Chief Economist who will build economic analysis into our significant rulemaking.

 

I believe in the SRO model of regulation. With the industry's support of strong regulation and with your continued engagement in our rulemaking process, we can best ensure that the SRO model will continue to protect investors and reflect the legitimate business practices of firms. That is the most effective regulation of all.

 

Thank you.

 

* J. Seligman, The Transformation of Wall Street 82 (1982, 1st ed.)