finra

Richard G. Ketchum

Chairman and Chief Executive Officer

Consumer Federation of America Consumer Assembly

 

Washington, DC 

March 14, 2013

As prepared for delivery.

 

Introduction

 

Thank you, Betsy [Costle], for that introduction, and thanks to Barbara [Roper], who wasn't able to join us today, and Steve[Brobeck] for inviting me to join you today.

 

I am honored to be here to participate in the conversation on how regulators and consumer advocates can work together to help consumers make smart financial decisions. And though we are looking at consumer protection from different angles—financial services and health and safety—we share a common goal: making sure smart choices are available to consumers.

 

Effective regulation is one of the factors that plays a significant role in ensuring consumers are protected when they choose to buy a financial product or service. Over the last few years, we have heard a lot about the different level of protections available when a consumer gets financial advice from an investment adviser versus a broker-dealer. We think the time is right to resolve this issue on behalf of consumers; and today, I want to talk about how a fiduciary standard can help ensure retail investors get the same basic regulatory safeguards and protections regardless of the type of investment professional from whom they get advice. I will also talk about the enhancements FINRA has made to its regulatory programs and our efforts to educate both industry participants and investors.

 

But, since some of you may not be familiar with FINRA, I want to start by telling you who we are. FINRA is the Financial Industry Regulatory Authority—an independent, non-governmental regulator for all securities firms doing business with the public in the United States. Our core mission is to pursue investor protection and market integrity, and we achieve our goals without costing taxpayers a single penny. FINRA regulates nearly 4,300 brokerage firms and about 630,000 registered securities representatives—and not just from our offices in Washington. We are out there on the ground and in the field every single day—in offices all across the country—overseeing virtually every aspect of the securities business.

 

In 2003, FINRA created the FINRA Investor Education Foundation, which provides underserved Americans with the knowledge, skills and tools necessary for financial success throughout life.

 

Many of you are familiar with the FINRA Foundation's long-standing interest in building financial capability for all Americans. Through the 2009, and now the 2012, National Financial Capability Study, the Foundation has gathered rich datasets that allow academics, policymakers and educators to advance our collective understanding of the relationships among financial literacy, financial capability and financial well-being. We partner with many of you to deliver our Military Financial Readiness program, as well as our innovative, research-based Investor Protection Campaign. And we support and engage in community-based outreach through libraries and local nonprofits nationwide.

 

I've personally had the opportunity to focus on financial capability through my participation on the President's Advisory Council on Financial Capability, which presented its recommendations to the president less than a month ago. Those recommendations share a common theme: building financial capability cannot be addressed in a vacuum but must be woven into the fabric of our lives—at home, in our schools, in the workplace, in our communities and finally, in the way we design and regulate financial products and services. And we need to embark on rigorous research and neutral evaluation to understand what actually works, for whom and under what circumstances. We at FINRA and the Foundation believe the optimal approach to financial capability involves a convergence of financial education, "choice architecture"—the behavioral economics concept that you can change consumers' behavior by changing their choices—and effective regulation.

 

It's that last piece that I'd like to focus on most during my time with you today: effective regulation.

 

Investor Protection and Market Integrity

 

Over the past five years, we've all heard a great deal about systemic risks in our markets. And that's an extremely important dialogue. But what keeps me up at night—and what FINRA can help address—are the challenges that impact retail investors. Today, we're confronted with a rapidly evolving financial marketplace. In any given year, or even month, a wide array of new and complicated products are being offered to retail investors, with hard-to-discern features and risks that are hard to weigh. This makes saving and investing increasingly complex for most Americans, and investors feel more vulnerable than ever before.

 

So how do we address this? Effective regulation is critical to our mission to protect investors. Given the ongoing change in the financial services industry, it's more important than ever that FINRA is prepared to respond quickly. To assure we meet this challenge, we have enhanced our regulatory program to focus on the greatest risks to investors. As part of our duty to regulate brokers, we examine firms for compliance with the rules and laws that govern the securities industry. Over the last few years, we began a process to shift this examination program to a more risk-based approach that would strengthen our ability to identify high-risk firms, brokers, activities and products. We developed new technology to support and streamline the process of examining firms, which is critical to identifying and prioritizing areas of risk exposure. It also helps us determine the appropriate regulatory response to those risks and improve our ability to quickly make decisions regarding how we pursue "red flags" and other areas of heightened focus.

 

Our goal is to address problems early and prevent harm to investors. And this is another area where we're on the ground and in the field—monitoring emerging trends from an investor-protection standpoint. In this zero-yield environment, where investors are understandably frustrated with the return on many of their investments, we're worried about investors taking on risks that they either don't understand or cannot afford. We understand that investors are frustrated and still nervous about the big losses they incurred during the credit crisis, especially those who sold off their stock holdings as the market reached bottom. But we also worry that current conditions leave investors reaching for yield in dangerous ways. For example, with fixed income products, which have long been considered less risky than stocks, we may face new problems if rates rise and bond prices plummet in the coming years. Knowingly or unknowingly, investors may actually be taking on more risk when they move to longer-duration or high-yield fixed income products—or to more complex products—in an attempt to avoid losing money on their investments.

 

What do we mean by the term "complex product'"? A product might be considered complex if the average retail investor has a hard time understanding how its features will interact under different market conditions, and how that interaction may affect potential risk and return. So we're concerned that investors may not always understand the risks they're taking on.

 

Take structured products, for example. Unlike traditional corporate or government bonds, structured products sold to retail investors typically involve unsecured debt and feature pay-outs that are linked to a variety of underlying assets such as a narrow or proprietary index or some other obscure benchmark. These products may be marketed to retail customers based on attractive initial yields and in some cases on the promise of some level of principal protection. However, these products are often complex, and have cash-flow characteristics and risk-adjusted rates of return that are uncertain or hard to estimate. In addition, these products generally do not have an active secondary market, which means investors must be willing to assume considerable liquidity risk in addition to market risk and the credit risk associated with the issuer of the product. These features can make the products unsuitable for some retail investors. We have reminded firms of their responsibilities to consider an investor's tolerance for risk, investment horizon and level of sophistication when assessing whether the product is suitable for that investor.

 

We're also concerned about certain closed-end funds, which retail investors may find attractive because these funds typically pay income regularly in the form of dividends, interest income, capital gains and/or return of capital. We are concerned that retail investors may not understand that some funds are returning capital to maintain the high distribution rates, causing the closed-end funds to trade at high premiums compared to their net asset value.

 

We've also reminded firms about their responsibilities regarding the sale and marketing of private placement securities. Specifically, we've reminded brokers that the scarcity of independent financial information and the uncertainty surrounding the market- and credit-risk exposures associated with many private placements means they must conduct reasonable due diligence on prospective issuers. Due diligence should focus on the issuer's creditworthiness, the validity and integrity of their business model, and the plausibility of expected rates of return as compared to industry benchmarks. Our primary concern is that inadequate due diligence regarding private placements could expose customers to harm and result in insufficient disclosure.

 

When we examine firms, we focus on due diligence policies and procedures, valuation processes, and place special emphasis on the integrity and independence of third-party valuation services, and the timely disclosure of material risks. We've also taken steps to improve our understanding of these offerings. We implemented a new rule requiring brokers that sell an issuer's securities in a private placement to individuals to file a copy of the offering document with us. We will use the information it provides to enhance our risk-based supervision of the private placements market and better identify and assess higher-risk transactions.

 

So given the environment, FINRA is particularly concerned about the suitability of the products registered representatives recommend to investors. Before recommending a complex product to a retail customer, financial advisers should be discussing the features of the product, how it is expected to perform under different market conditions, and the product's risks, potential benefits and costs. This means describing the circumstances under which the customer could lose money, not just those under which the customer would earn money. It also means explaining carefully the direct and imputed costs clients will incur.

 

At FINRA, we spend a lot of time thinking about what drives investment professionals to recommend products that are less than appropriate for their customers—or to make other mistakes that harm investors. One of our concerns is how firms identify conflicts of interest and ensure they place their customers' interests before the firm's. We understand that conflicts exist in the financial services industry. It's equally important for the industry to take a step back, acknowledge that there are risks and look at how it handles those conflicts.

 

Last May, in a speech I gave at FINRA's annual conference, I challenged brokers to assess whether their business practices place their—or their employees'—interests ahead of customers. I also called on firms to make sure that the products they sell are appropriate for each investor, to assess the potential risks associated with products that raise specific investor-protection concerns, and to disclose, where applicable, the fact that the firm or an affiliate is on the other side of the transaction.

 

A few months later, we initiated conversations with a number of brokerage firms to better understand how they identify and manage conflicts. Our goal is to better understand industry practices, and to identify both good policies and potential problem areas. Knowing what firms do to address conflicts and the challenges they face also helps us determine whether FINRA should issue guidance to the industry or consider other steps to improve how conflicts are addressed. In some cases, the selling challenges firms face point out where the culture of the industry has gone wrong. What is clear is that the culture has to evolve with respect to firms being able to document that their recommendations are in the best interest of investors.

 

It's also vital that we continue to work toward a uniform fiduciary standard for broker-dealers and investment advisers when they provide personalized investment advice about securities to retail customers. FINRA has explicitly supported a fiduciary standard of care for both channels, and we were pleased when the January 2011 SEC Staff Study on Investment Advisers and Broker-Dealers recommended SEC rulemaking to establish such a standard. On March 1st of this year, the SEC took another important step to move the ball forward, by asking for quantitative data and economic analysis to assist its consideration of what the appropriate standard of care should be.

 

But the SEC didn't stop there. The request also addresses whether investors would be better off if the rules were harmonized in other areas of broker-dealer and investment adviser regulation, such as advertising, supervision, licensing of firms, qualification of individuals, and books and records, to name a few. The SEC is right to continue the conversation about harmonizing more than just the standard of conduct.

 

FINRA believes, however, that a fiduciary standard, alone or coupled with other regulatory harmonization, is not a guarantee against misconduct. Compliance must be regularly and vigorously examined and enforced to ensure the protection of investors. As the 2011 SEC Staff Study notes, "to fully protect the interests of retail investors, the Commission should couple the fiduciary duty with effective oversight. " The SEC's ability to examine advisers remains inadequate. And, sadly, the SEC continues to find serious problems when it conducts exams. In fact, the SEC issued a Risk Alert and Investor Bulletin on March 4th after finding widespread non-compliance with the investment adviser custody rule. If investors are to be protected, investment advisers need to be examined regularly and vigorously. It's as simple as that, and it is not happening under our current system.

 

I also want to touch on another issue that's important to the discussion about conflicts of interest: compensation practices. Too often, recommendations to customers can be driven by direct and indirect compensation incentives to the financial adviser and the firm itself. Don't get me wrong—a world where investors are provided only fee-only "choices" leaves many lower-income or less-active investors disadvantaged. But we still can move much further toward ensuring that recommendations are, to the greatest extent possible, agnostic to fees and truly focused on the best interest of the investor.

 

We also believe investors should be informed of conflicts involving recruitment packages when they make the important decision to move an account, especially when the decision to move means having to sell off proprietary products and taking a possible tax hit. When a broker moves to a new firm and calls a customer and says, "You should move your account with me because it will be good for you," the customer needs to know all of the broker's motivations for moving. So in January, we proposed a rule that would require a broker-dealer that recruits representatives using enhanced recruitment compensation to disclose that compensation to customers solicited to transfer with the representative. We are reviewing comments we received on the proposal and will soon decide how to proceed.

 

Another central area we've focused on is making it easier for investors to make the right choice in selecting a financial adviser or financial firm. So we provide investors with a quick way to check a broker's and firm's disciplinary and professional backgrounds through our BrokerCheck® system. This free tool has background information on nearly 1.3 million current and former FINRA-registered brokers and 17,400 current and former FINRA-registered brokerage firms. Encouraging people to take this simple step before doing business—or continuing to do business—with a broker is part of our greater commitment to protecting investors. But we know from speaking with investors and conducting research that too few investors use it—fewer than 15 percent. It continues to amaze me that so many people immediately go to Yelp.com to check out a new restaurant where they might spend $25 for a meal, but don't think to use BrokerCheck when they're handing over $2,500—or $25,000 of their life's savings or even more—to an investment professional to invest. How can we change that? Here's how we're trying: Last October, we added a search engine optimization feature to ensure BrokerCheck is listed as a search result when investors look up investment professionals. And we have proposed a rule that would require brokers to include a prominent description of and link to FINRA BrokerCheck on their websites and social media pages.

 

Just as the challenging economic environment poses risks to investors, legislative changes can provide both new opportunities and challenges. Crowdfunding is such a challenge facing investors. The JOBS Act contains key capital-raising provisions relating to securities offered or sold through crowdfunding. The law also requires intermediaries performing crowdfunding on behalf of issuers to register with the SEC as a "funding portal" or broker, and also with an applicable self-regulatory organization. We are committed to doing our part to ensure investors are protected. Currently, we are analyzing the provisions of the JOBS Act and talking with the SEC and interested parties about approaches to implementing the crowdfunding rules. In the meantime, we've issued an interim form for prospective funding portals to voluntarily submit information regarding their business. We'll use the information to help us develop rules specific to crowdfunding portals.

 

While our goal is to address problems early and prevent harm to investors, we recognize that some bad actors will still break the rules, and we are aggressively vigilant about finding and disciplining those who do. In 2012, for example, FINRA brought more than 1,500 disciplinary actions against registered individuals and firms. We levied fines totaling more than $68 million and ordered restitution of $34 million to harmed investors. And we expelled 30 firms from the securities industry, barred 294 individuals and suspended 549 brokers from association with FINRA-regulated firms.

 

Most of us here are very familiar with the damaging effects of financial fraud. We responded to the significant fraud events of the last few years by heightening our focus on fraud detection and prevention. We've done so in a way that still encourages a culture of creating financial products and sales based on the best interests of investors, but allows us to respond quickly when there are indications of fraud or widespread customer harm. When we detect fraud, we take immediate action. In 2012, for example, we filed a temporary cease and desist order and complaint to halt further fraudulent sales activities by WR Rice Financial Services and its owner. We took immediate action based on the belief that ongoing customer harm and depletion of customer assets would likely continue before we could complete a formal disciplinary proceeding against the brokerage firm.

 

Last November, we charged the owner of a New York-based brokerage firm with defrauding three customers of more than $4 million. The broker targeted his own Polish community and converted client funds for his personal use. He also provided falsified account statements to his customers. We also routinely refer potential fraudulent conduct that is outside our jurisdiction to other regulatory agencies, including the SEC and law enforcement agencies. FINRA's Office of Fraud Detection and Market Intelligence (OFDMI) conducts a robust insider-trading and fraud surveillance program across nearly all U.S. equities markets. Last year, for example, OFDMI referred 692 matters involving potential fraudulent conduct to the SEC and other federal or state law enforcement agencies, including 347 insider trading referrals and 260 fraud referrals.

 

One investigation of note was an insider-trading case involving suspicious trading by multiple foreign accounts that generated more than $13 million in illicit profits by trading ahead of an acquisition announcement. Within hours after the acquisition was announced, FINRA alerted the SEC to the suspicious trading, leading to an emergency asset freeze.

 

The Role of Education

 

You know, a little earlier, I started out my remarks by focusing on how FINRA and the FINRA Foundation reach out to the investing public—and I'd like to circle back to that topic. FINRA very firmly believes that investor education is a critical component of investor protection. We have worked hard to develop a strong investor education outreach program. We produce alerts, interactive tools and educational content to help investors make wise financial decisions. And the FINRA Foundation engages in a variety of initiatives to reach investors at the grassroots level and to expand our channels of distributions. These include grant programs in partnership with the American Library Association and the United Way Worldwide—and we've learned that integrating financial education into existing programs where target audiences already congregate can prove very effective. Some of our grantees work financial education concepts into "English as a Second Language" programs, GED prep, homeowner education, probation programs and storytimes at public libraries. These "outside-the-box" approaches tend to take root because the reality is that many adult learners in some of our target audiences have not been successful in traditional learning environments. How can anyone expect them suddenly to be engaged by and successful in didactic forms of financial education? That strikes me as unreasonable and unproductive. So, through partners and grantees, we reach out where people are, and we meet them at their level. And, to the extent we can, we aim to make financial education fun—and to leverage the social dimensions of learning.

 

But we don't stop with investors. As part of our effort to be on the ground and in the field, we also help educate the very industry participants we regulate. It's critically important that brokers understand the products they sell and are trained on the features of the product as well as their firm's own suitability guidelines for that product. Brokers should also understand which clients should be or should not be considered for a particular product. So we work with compliance officers to help them oversee brokers and implement strong training programs. We do this in a variety of ways—from in-person meetings to Web-based podcasts and e-learning courses. But at the end of the day, firms are ultimately responsible for making sure their reps. have the necessary training. And we hold firms accountable when they fail to do so.

 

Close

 

In closing, I want to stress that building financial capability is a complex issue that requires all our combined efforts and vigilance. At FINRA, we view our regulatory responsibility as a three-legged stool—enforcement, compliance and education for both brokers and investors. Effective regulation depends on the support of each.

 

Thanks for listening.